Fed rates will remain in place, says the Fed, recession or not. The markets have a different opinion

If the US economy slips into recession in the second half of the year, as most forecasters expect, the Federal Reserve says it will take tough action rather than a lifeline.

There’s a good chance the Fed has suspended aggressive rate hikes but has repeatedly signaled that it’s unlikely to cut rates this year, even in a mild recession, because it wants to curb a historic rise in inflation.

The financial markets and some economists answer succinctly: nonsense.

Markets expect the Fed to cut rates by November and give a 30% chance it will take a step in September.

“They won’t stick to their word,” said Joe LaVorgna, chief US economist at SMBC Group and a former top economic adviser to the Trump administration. “There’s no way you’re going to watch (employment) go down” while job losses mount.

Pointing to past recessions, LaVorgna notes that the Fed typically appears to make a seemingly self-contradictory shift from fighting inflation to attempting to quickly avert or minimize a downturn when the economy is weakening . Since the 1950s, the average lag between the last rate hike and the first cut has been just two months, says LaVorgna.

Rate cuts would boost the stock market and the economy, but there is a risk of inflation rising further.

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How much has the Fed recently raised interest rates?

The Fed raised interest rates by a quarter of a point earlier this month, capping the hike by 5 percentage points in 14 months, its most aggressive campaign of its kind in four decades. According to Fed officials, rate cuts will not start until late January at the earliest, even in the case of the mild recession that Fed officials are forecasting for this year. That’s a nine-month delay. Such a tough stance in the face of numerous layoffs would be highly unusual.

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How does raising interest rates help the economy?

Jonathan Millar, a former top Fed economist, says this time is different because annual inflation has remained stubbornly high, falling to 4.9% in April from a 40-year high of 9.1% last June , which is still well above the Fed’s 2 percent target. Fed Chair Jerome Powell has said it is more important to contain inflation so it doesn’t take root in the country’s psyche like it did in the 1970s than to stave off a mild downturn that can be remedied by cutting interest rates.

Higher interest rates make it more expensive for consumers and businesses to borrow, dampen spending and encourage businesses to hold prices steady or raise them only slightly. But the Fed’s spate of rate hikes is also expected to be the main cause of a recession.

A large part of the Fed’s strategy rests not only on its actions, but also on its promises to raise interest rates or keep them elevated, as this rhetoric can influence consumers’ inflation expectations. If workers believe prices will continue to rise, they are more likely to demand wage increases, a cost that companies may offset by raising prices even more.

“Our view on the committee is that inflation is going to come down — not anytime soon, but it will take time,” Powell said at a news conference this month. “And if that forecast is broadly correct in this world, it would not be appropriate to cut rates and we will not cut rates.”

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Will the Fed Cut Rates Soon?

Powell suggested the Fed could cut rates if inflation falls faster, as some economists expect. It’s also possible that the collapse of Silicon Valley Bank and two other banks will continue to pose a threat to regional banks, with many customers withdrawing their deposits, accelerating the slowdown in lending. That could trigger a deeper downturn and bring inflation down faster — both of which could see the Fed cut rates within months, economists say.

“Chair Powell does not wish to discuss rate cuts at this time,” wrote Ian Shepherdson, chief economist at Pantheon Macroeconomics, in a note to clients. “But this will change; The Fed will do as the data tells it and the data is trending down.”

LaVorgna believes the Fed will cut rates this year in part because a recession will be deeper than the Fed expects. But he says the Fed will shift gears even if there is a mild to moderate slowdown as forecast and unemployment rises to 4.5% from the current 3.4%.

“The Fed isn’t usually good at knowing when it’s going to make a policy shift,” says LaVorgna.

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How did the Fed react to the Great Recession?

By August 2007, the housing crisis was already brewing, leading to the start of the Great Recession later that year. Many low- and middle-income homeowners were in default on their subprime mortgages, and banks had begun to restrict lending.

Then-Fed Chairman Ben Bernanke noted the financial strain, but added, “I think there’s a good chance the market will stabilize,” according to minutes from a closed Fed meeting.

Meanwhile, he said he still sees “risks” in inflation. While inflation fell to 2.4% in July from 4.1% a year earlier, Bernanke agreed with colleagues who believed the improvement may be temporary and that low unemployment (4.6%) is affecting wages and wages could drive up prices.

“I agree with those who still see the risk of inflation as sloping to the upside,” Bernanke said.

In its post-meeting statement, the Fed held interest rates steady, saying “sustainable moderation in inflationary pressures has yet to be convincingly demonstrated.”

Just three days later, the Fed cut its discount rate on the grounds of “dislocations in money and credit markets,” LaVorgna noted. And at its September meeting, the central bank cut interest rates by half a percentage point, followed by cuts of a quarter point in October and December.

“I’m concerned about anticipating potentially negative dynamics between the job market and the housing market,” Bernanke said at the September meeting. “In terms of inflation, I think the slowdown that we’re likely to see will likely remove some of the upside risk we’ve been concerned about.”

LaVorgna said the Fed’s current stance is “eerily similar,” citing the current regional banking woes.

However, Millar says the Fed’s dilemma was different in 2007. The 2007-2009 financial crisis was far more damaging as it hit the country’s largest banks, which were closely linked and severely curtailed their lending. Regional banks don’t have as big an impact on the broader economy, although a deepening crisis that spreads to more regional banks could hurt lending and growth more, Millar says.

He also points out that inflation is now 4.9%, double what it was in 2007, which made the Fed’s decision to cut rates easier at the time.

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What happened in the 1990-91 and 2001 recessions?

Inflation was also elevated in July 1990 and January 2001, at 4.8% and 3.7% respectively, and the Fed had left interest rates unchanged at historically high levels. But when the economy faltered in the face of high interest rates—along with an oil boom in 1990 and the dot-com crash in 2001—the Fed quickly changed tack and began cutting rates.

On November 15, 2000, the Fed noted that high energy prices could raise inflation expectations even as household and corporate demand eased. She kept interest rates stable, adding that “risks remain primarily biased toward conditions that could generate elevated inflationary pressures…”

On Jan. 3, the Fed reversed course, cutting interest rates by half a percentage point before losing 20,000 jobs that month. It pointed to “further weakening of sales and production … and high energy prices, which weaken the purchasing power of households and companies”. In addition, inflationary pressures remain contained.”

Millar says: “Inflation wasn’t nearly as big a problem then as it is now. So it was easier for them to make a decision.”

Still, LaVorgna believes a weakening labor market with tens of thousands of job losses a month could trigger a Fed about-face.

“When the economy crashes, they’re under tremendous pressure to do something about it,” he says.