The Federal Reserve, America's central bank, stands at a crossroads. Two years ago, it embarked on a mission to curb inflation by aggressively raising interest rates. Back then, homebuilder Dwight Sandlin of Birmingham, Alabama, envisioned a nightmare scenario – mortgage rates skyrocketing to a crippling 7%.
However, Sandlin's fears haven't materialized. He's coming off his most profitable year ever. While sales have dipped slightly, a dearth of existing homes for sale has kept prices buoyant, bolstering his profits. "The market remains firm, not booming, but firm," Sandlin asserts. "There's just one reason for this: a lack of inventory. If you can't make money building houses right now, you might want to consider a career change."
This week, the Fed convenes to grapple with a critical decision: when, if at all, and by how much to slash interest rates. A central question looms large – just how restrictive is its current monetary policy?
Conflicting Signals Cloud the Path Forward
Sandlin's experience, coupled with consumers' overall resilience, suggests the Fed's grip on the economy may not be as tight as initially perceived. This, in turn, weakens the case for significant or immediate rate cuts, especially considering two recent months of inflation exceeding expectations. You can find more details about inflation rates in the US on the Bureau of Labor Statistics website.
On the other hand, the current federal funds rate target (between 5.25% and 5.5%) is historically high, both nominally and after adjusting for inflation. Additionally, there are whispers of the economy's resilience waning – a concern Chair Jerome Powell himself has alluded to. If these whispers hold truth, the Fed's monetary policy could soon begin to bite, strengthening the argument for rate cuts.
Neutral Rates and Beyond
A key indicator of inflation – a gauge that surged to nearly 5% early last year – has dipped below 3% in recent months. However, due to inherent lags, the question of whether growth will endure or falter in the face of past interest rate hikes may not be fully answered for another six months.
The Fed raises short-term rates to cool inflation by dampening demand, hiring, and wage growth. The specific rate that fosters optimal economic conditions – where growth remains robust and inflation stays stable – is termed the "neutral rate." To impede growth and curb inflation, the Fed needs to push rates above this neutral level.
Business leaders, economists, and even some within the Fed believe current solid growth suggests rates may not be far above neutral right now. "We initially thought we were applying significant pressure on the brakes," observed Minneapolis Fed President Neel Kashkari, "but perhaps we only have one foot on the pedal, explaining the lack of a substantial demand reduction."
The Lingering Effects of Pandemic Stimulus
In the wake of the COVID-19 pandemic, the government showered the economy with financial aid, while the Fed slashed interest rates to near zero. Businesses and consumers locked in these ultra-low rates, initially mitigating the impact of the Fed's subsequent rapid tightening cycle two years later.
Furthermore, recent government spending on infrastructure and green energy projects has, according to Eric Rosengren, former president of the Boston Fed, "prevented the usual shedding of construction jobs typically observed during periods of higher interest rates."
Housing: A Market in Limbo
No sector exemplifies the post-pandemic resilience to high rates quite like housing. Historically, housing is the most critical channel through which the Fed's tightening measures slow the economy. While existing home sales have undoubtedly tumbled, prices haven't followed suit. This is primarily because many Americans, locked into favorable mortgage rates, are staying put. Additionally, a limited supply of available homes further strengthens sellers' positions.
"This housing market desperately wants to recover," asserts Ray Farris, an economist based in New York. "It's like a coiled spring, ready to launch."
Buoyed by rising housing prices and a near 20% stock market surge since November, consumer wealth and spending are enjoying a boost. You can find more details about the stock market performance on the Yahoo Financewebsite. Additionally, banks that initially adopted a cautious stance in anticipation of a recession may now be more receptive to lending.
Signs of Strain Beneath the Surface
However, there are reasons to suspect that the seemingly robust 2023 growth (at 3.1%) may not fully capture the true impact of the Fed's tightening policies.
Chair Powell has hinted that this growth may not necessarily stem from businesses that must devote more income to interest expenses. They point to other weaknesses. Commercial real-estate values have tumbled, and delinquency rates on office-backed loans jumped in December to 5.8%, according to S&P Global S&P Global website. Surveys show banks are pulling back from consumer lending. Interest rates on credit cards are near records, and credit-card delinquencies are rising. Retail sales in January and February were soft.
"You have to look at whether banks are willing to continue making loans to consumers, and the data suggests they're not quite as keen as they were a year ago or two years ago," said Peter Berezin, chief global strategist at BCA Research in Montreal.
Household savings buffers for lower-income consumers also appear to be exhausted. Bank deposits and money-market funds are below pre-pandemic levels when adjusted for inflation for all but the 20% most affluent households, said Berezin.
Ian Borden, chief financial officer at McDonald's, said last week that more consumers are eating at home. And executives at home builder Lennar said more prospective buyers were struggling to qualify for a loan because they had too much debt.
While job growth is strong and unemployment stable, the number of open jobs is declining and wage growth has slowed, which both point to cooler demand for labor.
The Tightrope Walk: Navigating Uncertainty
The challenge of deciphering these conflicting signals explains why Fed officials are laser-focused on inflation. If inflation continues to move lower, "you could say, 'Why keep rates where they are?'" Kashkari said. But if the economy is expanding solidly, it is fair to ask "why do anything?"
The Fed is caught in a precarious position. Raising rates too aggressively could trigger a recession, while keeping them too low could reignite inflation. This week's meeting will be keenly watched by financial markets and businesses around the globe, as the Fed attempts to thread the needle and achieve a soft landing for the economy.
Looking Ahead: Potential Scenarios
The coming months will be crucial in determining the effectiveness of the Fed's tightening measures. Here are two potential scenarios:
Scenario 1: Inflation Cools Further – The Goldilocks Outcome
If inflation continues its downward trajectory, the Fed may decide to hold rates steady or even implement modest cuts later in the year. This scenario would be ideal, fostering continued economic growth without reigniting inflation.
Scenario 2: Inflation Persists – The Challenge Deepens
If inflation proves more stubborn than anticipated, the Fed may be forced to raise rates further. While this would dampen inflation, it could also stifle economic growth and increase the risk of recession.
The path forward for the Fed is fraught with uncertainty. The decisions made this week, and in the months to come, will have far-reaching consequences for the American economy and potentially the global financial landscape.
