US Fed hikes rates despite recession fears

The Federal Reserve voted to raise interest rates Wednesday by another 0.25 percentage points, brushing aside concerns about the financial sector and an expected recession later this year.

The Fed’s rate-setting committee voted unanimously Wednesday to boost its baseline interest rate to a range of 5 to 5.25 percent, the point at which Fed officials expected in March to stop hiking rates, according projections from the Fed’s last meeting.

The latest rate hike is the 10th in a row since the Fed began its program of quantitative tightening in March of last year.

Over the past 14 months, the Fed has boosted borrowing costs and shrunk its balance sheet in a historically swift battle with inflation.

There is still some doubt about what the Fed will do at its next meeting in June as both the broader economy and inflation continue to slow. The collapse of First Republic Bank and deepening concerns about financial stability has also shaken confidence in the economy.

“The US banking system is sound and resilient,” according to a Wednesday statement from the Federal Open Market Committee (FOMC), the Fed’s rate-setting panel.

Even so, the FOMC acknowledged that “tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain.”

The Fed may pause on rate hikes and fulfill its March projections for the terminal rate. A rebound in inflation, however, could push Fed officials to keep boosting rates.

Inflation has been decreasing steadily since the middle of last year, with the annual inflation rate falling to 5% in March, according to the Labor Department’s consumer price index.

The broader economy is also slowing under the weight of Fed rate hikes.

US gross domestic product grew at an annualized rate of 1.1% in the first quarter, according to Commerce Department data, much slower than the 2.6% growth rate in the final three months of 2022.

While the unemployment rate has remained near 50-year lows, job gains have been slowing.

Economists expect this trend to continue with the Friday release of the April jobs report.

“The April jobs report should confirm that the labor market slowdown is well underway and that the economy is cooling,” EY economist Lydia Boussour wrote in a Tuesday analysis.

Boussour expects the US to have added 175,000 jobs in April, “a result that would imply a marked downshift in the three-month moving average of job growth from 345,000 to a much cooler 246,000,” she wrote.

Job openings also dipped to 9.6 million in March, according to data from the Labor Department Job Openings and Labor Turnover Survey (JOLTS) released Tuesday, the lowest number in nearly two years.

“JOLTS was a good case for signaling a pause in June,” said Claudia Sahm, a former Fed research director and founder of Sahm Consulting, in an interview with The Hill.

The failure of three major banks within two months and lingering concerns about the delayed impact of Fed rate hikes are also raising the stakes of future increases.

“Historical recessions related to financial market problems tend to be more severe and persistent than average recessions,” the Fed warned in the minutes of its March rate-setting committee meeting

 

Will BoE and US Fed be on the same page?

The US Federal Reserve has made it official that starting later this month, it will reduce their monthly bond purchases by US$15 billion ($10 billion Treasuries, $5 billion mortgage backed securities). By June 2022, the bond buying program should come to an end. 

The Fed explains that pandemic stimulus can start to be unwound as “substantial further progress in the economy has (been) made toward the Committee’s goals since December 2021.” They left interest rates unchanged, which was expected and continued to use the word “transitory” to describe inflation.  

While some investors believed they would drop this language, it did not seem to matter as once the dust settled, USD ended the day virtually unchanged (slightly lower) from its pre-FOMC levels against other the major currencies. Stocks and bond yields ended higher which should benefit JPY crosses.

Looking ahead to Friday’s non-farm payrolls (NFP) report, economists expect a significant recovery in job growth during the month of October.  A large part of this has to do with the slowdown in September, when non-farm payrolls rose by only 194,000. That number is expected to more than double this week with a consensus forecast of 450,000. 

According to ADP, private sector payroll growth was very strong last month but even though service sector activity hit a record high in October, the shortage of workers drove the employment index lower. As one of the most important leading indicators for non-farm payrolls, this suggests that while more jobs are expected in October, the increase may fall short of the market’s lofty forecast. 

Will BoE hike rate today?

While the countdown to Friday’s NFP report has started, analysts have shifted focus to the monetary policy announcement by the Bank of England (BoE) on Thursday. In many ways, the BoE rate decision should have a greater impact on GBP than FOMC did on the USD because the UK central bank is close to raising interest rates.

As the second major central bank to reduce asset purchases, the BoE has been leading the pack in unwinding pandemic support and with inflation surging, a small contingent of investors believe they could hike as quickly as Thursday. The market is pricing in a 60% chance of 15bp hike which means a full quarter point move is unlikely. However the central bank has done a smaller adjustment before so we can’t rule out that possibility completely.

BoE Governor Bailey and monetary policy committee member Saunders have suggested that an immediate hike may be needed but other policymakers want to see further improvements in labor market activity or evidence that inflation is less transitory before making the move.

With the Reserve Bank of New Zealand raising rates, Bank of Canada announcing ending to Quantitative Easing and the Fed beginning to reduce asset purchases, there is a decent chance for a rate hike by the BoE. It may not be a full quarter point, but it could be 15bp increase. 

The immediate tightening should be wildly positive for the greenback as it is not really anticipated. However, if they forgo a rate hike in November, then a hike in December becomes very likely.

In this scenario, analysts expect no change to be accompanied by hawkish comments which could be initially negative but ultimately positive for GBP. Either way, barring an unexpected surprise analysts see GBP strengthening post BoE announcement, particularly against EUR.