WASHINGTON, April 3 (Reuters) – Federal Reserve officials, increasingly convinced they have nipped a potential financial crisis in the bud, now face a difficult assessment of whether demand in the US economy is slowing, and if so, whether it will declining fast enough to bring down inflation.
While the Federal Reserve’s monetary policy meeting two weeks ago was dominated by concerns that two bank failures could risk broader financial contagion – a possible reason to postpone further rate hikes – the debate has quickly refocused on whether tighter monetary policy has begun has to show its effect on the overall economy or if interest rates have to rise even higher.
The decision will be crucial as the Fed plots the final steps in a historic cycle of rate hikes, with policymakers still hoping to avoid a deep economic downturn triggered by too much rate hikes, but also determined not to to do little and let inflation stay high.
The central bank’s nine rate hikes since March 2022 have pushed the benchmark federal funds rate from near zero to its current range of 4.75% to 5.00%, a tightening not seen since Paul Volcker was Fed Chair in the 1980s watch was . Consumer and business interest rates have followed suit.
However, data released on Friday showed that the Fed’s preferred measure of inflation is still 5% annually, more than double the 2% target, and forecasts released by Fed policymakers on March 22 suggested indicated that interest rates would have to rise a little more. Also embedded in these forecasts is the rise in the unemployment rate to 4.6% by the end of the year from the current 3.8% and the slowdown in growth typically associated with a recession, which Fed Chair Jerome Powell and his colleagues are still claiming can avoid.
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“It’s absolutely a balance … There are uncertainties,” Boston Fed President Susan Collins said in an interview with Bloomberg Television on Friday. “We have to weigh the risk of not doing enough… not staying the course and not bringing down inflation… At the same time, I’m monitoring the data and looking at when we might see the economy turn. … It is still early.”
Richmond Fed Chairman Thomas Barkin struck a similar tone last week. “Inflation is still very high. The labor market is still very tight,” he told reporters. “When you raise interest rates there is always a risk that the economy will weaken faster than it otherwise would have. If you don’t raise interest rates, there is a risk that inflation will spiral out of control.”
That back-and-forth will play out until the next Fed policy meeting on May 2-3, when officials will decide whether to push another quarter-point rate hike and signal more rate hikes are to come, or postpone until early evidence that consumers are finally feeling the pinch of tighter credit and higher borrowing costs.
CREDIT CONCERNS
On an inflation-adjusted basis, consumer spending fell in February, while more recent weekly data on credit card spending from retail banking giants like Citi and Bank of America pointed to a pullback by consumers. Consumer sentiment has also fallen, which could be a possible harbinger of austerity.
The release of the Labor Department’s jobs report next Friday in March will be an important snapshot for the Fed on whether a red-hot job market is cooling – something that would also cause demand to slow.
Investors are currently viewing the Fed’s rate decision next month as a fall, the first since the current tightening cycle began in March 2022.
Concerns remain about the banking sector and the state of credit markets.
At the last Fed meeting, Powell warned that even if more bank failures are avoided, lenders may become more cautious and, by restricting access to credit, slow the economy faster than expected. That’s partly how monetary policy should work, but if the process goes too far or too fast, it could increase the risk of a recession, Minneapolis Fed President Neel Kashkari has warned about.
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However, the possibility of an acute crisis seems to have receded. The Fed’s emergency lending to banks, which had skyrocketed in the week following the March 10 collapse of Silicon Valley Bank and the collapse of Signature Bank two days later, fell last week in a sign that the stress in the financial sector slowed down.
Total bank lending for the week ended March 22 fell slightly to a seasonally adjusted level of $17.53 trillion from $17.6 trillion the week before. Bank deposits declined overall, but rose slightly among the smaller institutions, which have been the focus of recent financial tensions.
Even if credit slows or collapses, it may not necessarily translate into less spending – and lower inflation – as long as the labor market stays as strong as it is.
“People will keep spending as long as they get paid,” said Yelena Shulyatyeva, senior US economist at BNP Paribas. “They’re getting a little less access to credit, is that really going to affect decisions? It will, but only to the point where they stop getting paid” because of a slowing economy and rising unemployment.
‘MARKED CHANGE’
But regardless of how much or little an impending “credit crunch” will affect the economy, there are signs that consumer behavior is already changing.
The personal saving rate, for example, has risen steadily from 3% – a pandemic-era low and well below levels in recent years – to 4.6%, a textbook reaction to the higher returns savers can now earn from money market funds and other short-term money accounts, where there is less disposable income left over for spending.
Recent spending and savings data show “a clear shift in consumer behavior… with inflation calling for more caution,” wrote Diane Swonk, chief economist at KPMG, after the release of the latest personal spending statistics last week.
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A recent drop in consumer sentiment has been accompanied by a fall in inflation expectations, which may give the Fed confidence to be more cautious about further rate hikes, allowing the inflation battle to drag on for a longer period but with less risk of a full-blown inflation-on recession.
Karen Dynan, an economics professor at Harvard University and a senior fellow at the Peterson Institute for International Economics, said her prospects are that the Fed will face an anti-inflation “slog” that will require further rate hikes, but because of the strength of fiscal balance sheets and the labor market avoid a recession.
The recent bank stress “has done a bit of the Fed’s job, but I don’t see it as a full replacement,” she said.
Ultimately, the labor market will have to soften at least somewhat, reducing demand and dragging the US economy’s output far enough below potential for prices to fall.
“I don’t think increasing ‘slack’ is the whole story,” Dynan said, with things like improved supply and falling rents helping to slow the pace of price increases, but “some cooling in consumer and labor demand will.” to be required”.
Reporting by Howard Schneider; Adaptation by Dan Burns and Paul Simao
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Howard Schneider
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