No Surprises From the Fed as it Hikes Rates a Quarter Point While Declaring the Banking System ‘Sound and Resilient’

The Federal Reserve increased interest rates by a quarter point on Wednesday, firmly in line with market expectations while also affirming that the banking system is “sound and resilient.”

The move represents a careful balancing of risks for the central bank, continuing its fight against inflation while also seeking to assure Americans that their banking system is safe following the recent failures of three banks.

“The US banking system is sound and resilient,” the statement said, while also acknowledging the economy is seeing “modest growth in spending and production.”

“Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation,” the Fed added. “The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.

Prior to the two-day meeting, there had been expectations of a larger, 50-basis-point hike as economic data early in the year came in above forecasts. But the sudden downturn in the banking industry, with the collapse of Silvergate, Silicon Valley and Signature of New York banks, raised fears that the Fed’s rapid increase of interest rates might be doing too much damage to the financial system.

The Fed has come in for a lot of criticism in recent days, from politicians like Democratic Sen. Elizabeth Warren of Massachusetts to tech titan Elon Musk who worries the central bank is putting Wall Street ahead of Main Street and encouraging unemployment to thwart inflation.

But the Fed also finds itself caught by its past performance, when it insisted inflation was “transitory” for much of 2021 as prices for common goods such as gasoline and groceries surged. The Fed began raising rates in earnest a year ago, and since then the economy has proven more resilient than expected despite both the housing and manufacturing sectors experiencing major slowdowns.

The Fed’s statement left open the option for more rate hikes in the future.

“The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time,” it said.

“In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments,” the Fed added.

Fed Chairman Jerome Powell has repeatedly cited the experience of the late 1970s and early 1980s when the Fed stopped raising rates thinking inflation had been slayed only to have to raise them again to extreme levels. But some say the Fed is relying on an old playbook and needs to pause to see the lagging effects of its rapid tightening of monetary policy.

“They don’t have the luxury, if it ever was one, of having to just focus on inflation,” says Jim Baird, chief investment officer at Plante Moran financial advisors.

The banking crisis has exacerbated those concerns, as the sharp increase in interest rates caused problems for banks that hold long-term government bonds that have lost value. Some, like SVB, were forced to sell securities at a loss to meet withdrawal requests from customers. There are concerns that banks will now slow down their lending, leading to a credit crunch across the economy.

Dan North, chief economist for North America at Allianz Trade, said ahead of the Fed meeting that he thinks “it should be zero” in terms of how much rates should go up.

“You’ve already got inflation having peaked,” North said. “If you look at the real economy, personal consumption, retail are both down, the housing market is in shambles, manufacturing is in a recession. Why would you raise rates in the teeth of all that?”

There are signs that inflation has come down materially from its highs of last summer, when the consumer price index breached the 9% annual level. The three-month average for the CPI is now below 4%, although that is still twice that of the Fed’s target of 2% even though the central bank tends to follow a more narrow measure of pricing.

One of the problem areas for officials has been rents. Because of the way the government collects its data, changes in rents take a long time to show up in the official price statistics. And housing has been a key driver of inflation.

But, a recent report from rent.com finds that the growth in apartment rents has slowed down materially since last year. The national median rent is now $1,937, down from $1,942 in January, and the lowest median rental price since February 2022.

“Prices peaked in August 2022 at $2,053, after rising above $2,000 for the first time in May of that year,” the report noted. “February’s rent level represents a 5.65 percent decrease from August’s peak.”

“Broad trends across the rental industry, including increased vacancy rates, new inventory, a cooling housing market and demand below seasonal norms are driving price slowdowns,” it added. “But so too are price comparisons that today are also being measured against rents that had increased by historic levels just a year ago.”

Inflation expectations have also come down. The most recent reading from the Federal Reserve Bank of New York found expectations for inflation a year from now had fallen 0.8 percentage points to 4.2%. Three-year ahead expectations held steady at 2.7%.

Stocks, especially those of regional banks, have rallied in the past two days as officials have moved to assure depositors their money is safe while providing a variety of loans and other financial backstops to banks. But that is also a reflection that some investors are betting the Fed is done with raising interest rates and that its next move might be to cut rates. Bond yields have also fallen but that reflects a rush of purchases of government bonds, often seen as a safe haven in turbulent times.

“Disinflation is never costly; Recessions are never pain-free as they involve job losses, credit tightening and modest bankruptcies,” Vanguard senior economist Andrew Patterson wrote on Tuesday. “A deterioration in financial conditions has long been part of our baseline expectations for a mild recession in 2H this year. Conditions would have to get materially worse from here for a change in our perspectives on macro fundamentals.”