Not done yet.
That was the message Federal Reserve Chair Jerome Powell delivered at the June 14th Federal Open Market Committee meeting. Despite opting to pause on increasing rates for the first time in fifteen months, Powell indicated that more increases are likely in the future. The Committee increased their projections for the federal funds rate, raising it from 5.25% to 5.60%. This implies the possibility of at least one, and potentially two, additional quarter-point rate hikes this year. Other central banks have followed suit, with the Bank of England surprising markets with a 0.50% hike. The BoE’s move aligns them with the Bank of Canada and the Reserve Bank of Australia, both of which have increased rates by a similar amount.
All of these central banks are grappling with the same challenge: high inflation. While overall inflation in the U.S. slowed significantly from a peak of 8.9% in June 2022 to 4.1% in May 2023, core inflation (as measured by the Consumer Price Index which excludes food and energy prices) has proven to be more persistent. During the same period, core CPI experienced only a modest decline from 5.9% to 5.3%, with the prices of services and some sectors of the economy, like housing and automobiles, remaining especially sticky. The Fed has set 2% as its long-term inflation target, although most view this as an aspirational goal, unlikely to materialize in the near future. While we anticipate that both overall and core inflation will continue to decline, we believe that additional rate hikes by the Fed will be needed in order for them to achieve their objective.
As the Federal Reserve raises interest rates, they are applying brakes to economic growth. Higher rates translate to tighter credit conditions and increased capital costs for companies making investments. This more difficult borrowing environment became more pronounced following the recent failures of several banks, as healthier banks grow more cautious in their lending activities. Chair Powell has acknowledged that the cost of bringing inflation under control will likely result in growth below the expected trend and some softening in labor market conditions. Treasury Secretary Janet Yellen has echoed this sentiment, suggesting that curbing inflation may necessitate a slowdown in consumer spending. The labor market presents an additional challenge, as indicated by the Department of Labor’s JOLTS survey, which estimates that approximately ten million job openings remain. With an unemployment rate of 3.7% in May, and record-low layoff figures, addressing current labor market conditions adds complexity to the situation.
The resilience of the labor market has been the primary factor preventing the economy from entering a recession. However, as we move further into the year, we anticipate a deceleration in growth. As growth slows, the likelihood of a recession increases. The heightened uncertainty associated with sluggish growth can trigger a self-fulfilling slowdown. All components of demand – including consumers, businesses, international trade, and governments – tend to exercise greater caution in such circumstances. It is important to keep in mind that all expansionary cycles eventually come to an end, especially those driven by prolonged periods of low interest rates. While we acknowledge the potential for a recession this year or next, we do not expect a severe contraction due to the robustness of the labor market and the strength of consumer demand.