Give Time…Time

Question:  

What do you think the Fed will do with rate hikes in September?

Answer:

When the Federal Reserve Open Market Committee (FOMC) meets again September 20-21, 2022, it is expected to increase rates by 50 - 75 basis points. The current rate is 2.25% - 2.50% after a 0.75% increase at the last meeting on July 28, 2022.

Fed Chairman Jerome Powell has called for additional rate hikes to slow down inflation. In theory, higher interest rates slow economic activity and demand, presumably slowing inflation. It’s unlikely that rate hikes alone will cure the inflation. The Fed isn’t backing off, with some economists predicting a rate hike of 0.75%.

The FOMC sets the target interest for the federal funds rate. This rate is the rate that commercial banks lend excess reserves to each other on an overnight basis. The Fed meets eight times a year to set this rate in response to overall economic conditions. The fed funds rate can influence lending rates across the financial system.

Typically, it takes time for the economy to digest these rate hikes. Fiscal efforts to fend off the effects of the pandemic with easy money went too far. This took place when Americans did not have the opportunity to spend. The excess supply of money and slowed demand in many areas of the economy led to pent up demand with loads of cash on the sidelines. This created an inflationary environment with too many dollars chasing too few goods and services. Excess spending has slowed, and consumers are shifting back to more normal spending habits. The trick is navigating our way through higher prices on the staples of life such as food and energy. 

The Fed may be best served by being patient. The recent rate increases are slowing economic activity as seen in the housing sector. Also, real personal income levels have declined from their peak levels. Many of the factors that were pushing prices higher appear to be behind us. In other areas the Fed has no control over prices such as the war between Ukraine and Russia. This caused inflation to be higher than expected this year due to rising energy and food prices. Another example is drought conditions in the United States putting pressure on food prices. The Fed does not have control over the weather, geopolitics, or supply chain interruptions. Waiting for monetary policy to work through the system as external forces evolve may be prudent.

Primary Purpose

The two principal objectives of the Fed are to maintain low unemployment and stable prices. If interest rates increase too much, the economy could go into a deeper recession and unemployment will increase. If it’s challenging for Americans who are employed to get through the month with current income/wage levels, imagine what will happen and how much more difficult it will be if they’re laid-off because of cutbacks by employers. The Fed should be cautious and understand that higher nominal wages are not the pure cause of higher prices in our competitive marketplace.

Nominal wages do not consider inflation rates. Real wages take into consideration inflation rates and the purchasing power of compensation. Nominal wage increases in the leisure and hospitality industry is driven by the need to entice workers back to certain sectors after the pandemic. In my opinion, wage increases are the result of competitive market forces and not the reason why inflation is going higher. According to the Bureau of Labor Statistics, real wages have fallen in the goods and services industries. 

Initial jobless claims and home sales are currently on the decline. The Conference Board Leading Economic Index Board showed that the index leading economic indicators declined in July for the fifth consecutive month. This suggests that recession risks are rising in the near-term. The Conference Board “projects the US economy will not expand in the third quarter and could tip into a short but mild recession by the end of the year or early 2023.” The leading economic indicators confirm a weaker economic environment, but perhaps is not as close to recession as the Conference Board suggests. Manufacturing and service indices along with industrial production remain in expansion mode, even if the growth rates are slowed. This may be the time to give time time allowing higher interest rates to work their way through the economic system. Stay focused and plan accordingly.