Will the Fed maintain hawkish monetary policy?
In a move widely anticipated by markets, the US Federal Reserve (Fed) slowed down its pace of rate hikes, boosting the overnight borrowing rate by half a percentage point in its last meeting of 2022, taking it to a targeted range between 4.25% and 4.5%.
Softening inflation data in November and other key economic indicators have raised hope that the pace of the Fed rate hikes will continue to slow in 2023. The Fed itself, however, indicated that it expects to keep rates higher through 2023, with no reductions until 2024.
We took a look at institution’s historical rates policy, the factors that may influence the Fed’s decision and attempted to answer the question, when will the Fed raise rates?
What is the Fed?
The Federal Reserve System is the central bank of the US, established in 1913 by the US Congress to create and maintain a secure and stable monetary system. The bank is commonly referred to as the Fed.
Today the Fed is responsible for the country’s monetary policy, banking supervision and financial services. The US interest rates are set by the Federal Reserve. The central bank has three main entities: the Federal Reserve Board of Governors, the Federal Reserve Banks and the Federal Open Market Committee (FOMC).
The Board of Governors, headquartered in Washington, DC, oversees the 12 Federal Reserve Banks and provides them with general direction, reporting directly to Congress. With the Senate’s advice and consent, the US president appoints the board’s seven members.
The Federal Reserve Banks is a network of 12 banks and 24 branches. It is the operating arm of the Federal Reserve System. Each bank works within its respective geographic area or district.
The role of the Reserve Banks’ boards is similar to a board of directors in a private company. It is responsible for overseeing the bank’s administration and governance, budgets and overall performance, supervising the bank’s audit process and developing broad strategy and goals.
The FOMC is the body that sets national monetary policy. It makes all decisions regarding the Fed’s stance on monetary policy, including making Federal Reserve interest-rate decisions. The FOMC was created through legislation enacted by Congress in 1933 and 1935.
The FOMC has 12 voting members. They consist of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and four of the remaining Reserve Banks’ presidents.
The Fed’s monetary policy over the years
In 2018, two years before the full impact of the Covid-19 pandemic, the Fed had four rate hikes – in March, June, September and December – with a quarter-point increase each, bringing its benchmark rate range to 2.25%-2.50% by the end of the year.
The Fed loosened its monetary policy the following year by reducing the benchmark interest rate three times. The cuts lowered the Federal funds rate to 1.50% in October 2019, from 2.50% in January 2019. The Fed kept the rate band at 1.50% until Covid-19 emerged in the US in March 2020.
In March 2020, at the onset of the pandemic, the FOMC held two emergency meetings to cut the rate and help the economy weather the pandemic-induced crisis.
On 3 March 2020, the committee lowered the benchmark rate by 50bps to bring it to a target range of 1% to 1.25%. In the second emergency meeting on 14-15 March 2020, the Fed slashed the rate by 100bps to bring it close to zero until the first quarter of 2022.
Since the beginning of 2022, the Fed had signalled aggressive rate hikes as part of its tightening monetary policy to combat rising inflation. The Fed hiked rates by 25bps to 0.50% in March 2022 amid rising inflation. It was the first Federal Reserve interest rates hike since 2018.
The Fed raised the funds rate by 50bps in May, despite inflation slowing from 8.5% in March to 8.3% in April.
The rate was then increased by a surprise 75bps to a range of 1.50% to 1.75% during the FOMC meeting on 16 June 2022 as US inflation accelerated to 8.6% in May, exceeding the April reading. It was the most aggressive rate hike since 1994.
In July, the Fed hiked rates by another 75bps against market speculations of a 100bps interest rate increase to tame inflation that rose to a 40-year high of 9.1% in June.
The Federal Funds rate has had six further hikes since the Fed started its tightening cycle in March, taking the rate to a range% of 4.25 to 4.50% in December.
Factors that influence the Fed’s decision
There are several factors that can affect the Fed’s interest rate decision. Ideally, the central bank’s policy should be a balancing act of taming inflation without causing a recession.
To inform their decision, the FOMC members will be looking at the key inflation metrics such as CPI, the producer price index (PPI) and other statistics, as well as economic growth indicators such as employment figures.
The Consumer Price Index (CPI) measures the inflation of everyday products and services related to living expenses. The CPI reading has eased to 7.1% in November year-over-year (YoY), from a surprise 9.1% in June, which was the largest 12-month increase since the period ending November 1981.
November’s inflation figures marked the fifth month of consecutive decline, and constituted the “smallest 12-month increase since the period ending December 2021”, according to the US Bureau of Labor Statistics.
Energy has remained the biggest contributor to the index increase, rising 13.1% in the past 12 months. Gasoline prices rose by 10.1% over the span and fuel oil prices jumped 65.7%. Core inflation that excludes food and energy came at 7.1% from November 2021 to November 2022.
Strong employment data
The nonfarm payrolls increased by 263,000 in November, well above the market forecast of 200,000, but the weakest reading since April 2020, according to data aggregator TradingEconomics. The unemployment rate remained unchanged at 3.7%, bringing the number of unemployed people to 6.01 million.
James Knightley, ING’s chief international economist, wrote on 2 December:
Producer Price Index
The Producer Price Index (PPI), which measures the prices of goods, advanced 0.3% in November – the same rate as in August, September and October, due to a 0.4% increase in prices for final demand goods. On an unadjusted basis, the index increased by 7.4% for the 12 months ended in November.
Consumer spending saw a modest gain, with US retail sales down 0.6% from the previous month, but 6.5% above November 2021.
Retail trade sales were down 0.8% from October and 5.4% above last year. Sales at gasoline stations were up 16.2% on November 2021, while sales by food and drinking outlets were up 14.1% from last year.
Industrial production output
US total industrial production in November fell by 0.2%, according to the Fed’s report published on 15 December. Decreases of 0.6% for manufacturing output and 0.7% for mining “were partly offset by a rebound of 3.6% for utilities following three months of declines”.
When will the Fed raise rates?
The Federal Open Market Committee’s next meeting will be on 31 January and 1 February 2023. What are the analysts’ outlooks about the Fed raising interest rates? Are they forecasting a 75bp or a smaller hike?
ABN-Amro expects the Fed to continue slowing the pace of its rate hikes, forecasting a raise of 25bps each in its February and March 2023 meetings. The smaller rate hikes would lift the rate to 5% by March, the Dutch multinational lender predicted on 9 November
The bank believes the Fed will start rate cuts in September 2023 with a 25bps reduction, followed by two 50bps cuts in November and December 2023.
ING Group favoured a 50bps hike in the first quarter of 2023, though it thinks it should mark the top. ING’s James Knightley wrote on 15 November:
ING forecast the Federal Funds rate to stand at 5% in Q1 2023. The Fed was expected to cut the rate to 4.5% in Q3 2023 and to continue lowering it to reach 2.5% in Q4 2024, before gradually raising it to 3% by Q4 2025.
ANZ Research also projected the upper bound of the US policy rate to reach 5% in Q1 2023, with the forecast saying the central bank would likely keep the Fed Reserve rate unchanged until early 2024. ANZ Research’s economists Tom Kenny and Arindam Chakraborty wrote in a note on 14 November:
The bottom line
The majority of analysts expect the pace of the Fed’s rate hikes in 2023 to slow, as indicated by its 50bp rise in the last meeting of 2022, before loosening its monetary policy in H2 2023.
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How does the Fed interest rate work?
The Fed’s hike or cut of the benchmark funds rate influences the prime rate, which is the credit rate that banks offer to their lending customers. A rise or fall in the prime rate will affect other interest rates, such as mortgages and personal loans, resulting in boosting or slowing down of spending.
How does the Fed rate affect mortgage rates?
The Fed’s funds rate directs the prime rate, which consequently has an impact on mortgage rates. For example, when Fed’s benchmark rates rise, the mortgage rate available to consumers will rise along with it. On the contrary, when interest rates fall, so do mortgage rates.
When will interest rates go down?
Analysts cited in this article have suggested the Fed will continue to increase rates until the second half of 2023. Dutch banks ABN Amro and ING have both forecast that the Fed will cut interest rates in H2 2023. However, remember that analysts’ projections on the Federal Reserve interest rate could be wrong. The Fed will take into account the inflation rate, employment, retail sales, the producer price index and many more factors before making a decision to lower interest rates. Always do your own research when trading and investing.