We believe the quarter-point policy rate hike announced at the May Federal Reserve meeting will likely be the last hike of this cycle. Fed Chair Jerome Powell sought to keep the central bank’s options open by saying that all decisions are data dependent, but the shifting balance of risks appears to favor a pause. Inflation remains well above target, but banking sector stress and tighter lending standards pose growing downside risks to U.S. economic activity. Fed officials wouldn’t want to send the economy into a more severe recession than may be necessary in their efforts to bring down inflation.
Shifting to a holding pattern
In their statement following the May Federal Open Market Committee (FOMC) meeting, Fed officials signaled their willingness, and perhaps intent, to pause rate hikes to assess the impact of their swift 500-basis-point tightening campaign, which has brought the policy rate above 5% for the first time since 2007. Though Chair Powell in his press conference emphasized the potential to hike further if inflation remains stickier than expected, he also said that he believes monetary policy is tight, with the fed funds rate now “meaningfully above” estimates of neutral. Reaffirming this message, the statement also noted that tighter credit conditions are likely to weigh on economic activity, hiring, and inflation.
We interpret these communications as indicating the Fed is now ready to hold rates at restrictive levels, and view the May meeting as marking a shift in stance from Fed officials in response to what increasingly looks like a two-handed economy instead of elevated inflation risks outweighing everything else. On the one hand, U.S. inflation has not eased as much as Fed officials have hoped. Across a variety of price and wage indicators, inflation appears stubborn at levels that are not consistent with the Fed’s 2% inflation target. On the other hand, however, downside risks to real economic activity are mounting as tight monetary policy works its way through the economy.
Risk management considerations are evolving
Central banking strategy relies heavily on risk management, and risks appear to be evolving. While Chair Powell has continued to emphasize that the risks of the Fed doing too little to fight inflation are greater than the risks of doing too much – and inflation continues to look sticky – we believe that downside risks are building, and the May Fed statement suggests that Fed officials agree.
After a period of relative calm following the March FOMC meeting, banking sector stress and related equity market volatility resurfaced in the days before the May FOMC meeting. As we emphasized in our blog post, “Bank Failures and the Fed,” these trends are likely to constrain bank lending and exert a material drag on activity in the quarters ahead.
Based on our analysis of historical episodes of banking crisis, we find that after a persistent 30% decline in the value of bank equity, loan growth has tended to fall, exerting a 1 to 2 percentage point drag on real GDP over several quarters. Importantly, this has occurred even in the absence of bank deposit runs.
Tighter financial conditions appear to be compounding risks for the banking sector, and by extension could further curtail economic activity, demand, and eventually inflation. As these risks continue to evolve, we believe the May FOMC meeting is likely to mark the end of one of the most rapid Fed tightening cycles in history.
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