The US Federal Reserve should feel vindicated in its decision to pause rate hikes at its policy-setting meeting last month. Unfortunately, it seems to be about to breed them again. Forgive the cliché, but this risks snatching defeat from the jaws of victory. For now, the Fed should stay put and keep rates where they are. Climate change may be causing sweltering temperatures, but US inflation is cooling. The consumer price index rose just 3 percent in June, a sharp drop from a peak of 9.1 percent in June 2022. The rate of increase in producer prices slowed even faster. Stubborn increases in housing and utility costs have slowed significantly. And a separate analysis by Morgan Stanley of raw data taken from new leases shows that residential rents actually fall in some cases. Meanwhile, the economy remains strong. Unemployment is 3.6 percent. June brought with it 200,000 new jobs. These trends provide hope that inflation can be significantly reduced, if not defeated, without stifling the economy, as long as the Fed does not overdo it. Over the past 15 months, the Fed has tightened at an astonishing pace. It has raised rates from near zero to north of percent.
In April, a common measure of money supply, M2, had fallen 4.6% year over year, the largest drop since the Fed began formally tracking M2 in 1959. The economy needs time to adjust to these seismic shifts in Job Function Email Database monetary conditions. monetary conditions, particularly given that the Fed kept rates near zero for 14 years. The economy appears to be adjusting, so far, but there are still several shoes to fall. Trillions in corporate and commercial real estate have not yet been restored to higher rates, but will need to be refinanced in the coming years. Households are still benefiting from cash cushions built up during the pandemic, but will feel the impact of higher borrowing costs once those funds are depleted. While the labor market remains healthy, private sector employment growth has slowed noticeably. Workers and small businesses are particularly at risk if rapid rate increases cause more banking problems. This, in turn, adds pressure on regional and community banks.
The Fed's primary focus on raising short-term rates has resulted in a "yield curve inversion," a market aberration where short-term borrowing costs are actually higher than long-term rates. If this persists, it represents an existential threat to smaller banks whose profits depend on their ability to use short-term deposits to make longer-term loans at higher rates. If the Fed raises rates again, as appears certain at this week's meeting of the policy-setting Federal Open Market Committee, it could soften the impact by raising only rates on bank reserves, while leaving the rate it pays to funds of the money market and other non-bank financial intermediaries where it is. Using new tools given to it by Congress in 2008, the Fed can increase the interest it pays banks on their reserve accounts when it wants to raise rates. This gives banks an incentive to keep their reserves at the Fed unless they can achieve a higher risk-adjusted return by lending them out. In 2013, without authorization from Congress, the Fed created an “overnight reverse repurchase facility,” the functional equivalent of a reserve account for nonbank intermediaries such as money market funds, which pays rates almost as high as those paid into bank reserves.