During their May 2 and May 3 meetings, the Federal Reserve’s Federal Open Market Committee (FOMC), which meets eight times per year and consists of seven Presidential appointments, New York Federal Reserve’s President and four other rotating District Presidents, opted to raise interest rates again by 0.25% (or 25 basis points). This marks the tenth consecutive meeting since March 2022 where the FOMC has opted to raise interest rates from a 0% to 0.25% target range to the current 5.0% to 5.25% target range. This interest rate is formally known as the “Federal Funds Rate” and is the rate offered to any financial institution for any short-term borrowing needs.
Initially, the Federal Reserve used this short-term Federal Funds Market borrowing tool to allow financial institutions to bolster their balance sheet in times when they sustained severe losses in deposits (AKA “bank runs”). With time, however, financial institutions began borrowing Federal Reserve Funds during good times and the Federal Reserve soon realized they had an economic tool on their hands. They soon established a “Dual Mandate”, in which their policies would either help facilitate economic growth (cutting interest rates or keeping them low) or try to contain excessive inflation (raising rates or keeping them elevated). This is the basis of the Monetary Policy discussed in economics courses.
|
|
For example, during 2020 the COVID-19 pandemic rates were lowered to the 0% to 0.25% target range through March 2020 and the Federal Funds Rate was 2.25% to 2.50% range through most of 2019. Rates were kept low for the rest of 2020 and all of 2021, but inflation concerns from possibly overreacting due to the 2020 COVID-19 pandemic began to rise. Normally, the Federal Open Market Committee likes annualized inflation rates to be between 2% to 3%. Through June 2022, the annual inflation rate was at 8.6%, which was the highest it has been since the early 1980s (when the Federal Reserve significantly raised interest rates to calm that inflation as high as 13.7%).
|
As I’ve noted, the response to the COVID-19 pandemic may have been excessive with money creation and caused inflation years later, and now raising interest rates too much may significantly slow down the economy. Remember, the Federal Funds Market offers short-term borrowing to financial institutions. When rates are low, they tend to borrow more, but when rates go up, they borrow less. This translates into a “cost of production” issue, as most financial institutions offer what is called a Prime Rate to their most credit-worthy clients. Typically, the Prime Rate = Federal Funds Rate plus a 3% margin. Thus, during July 2021, companies could take out a loan or use a line of credit with a 3.25% Prime Rate (from 0.25% Fed Funds Rate), but now, Prime Rates are potentially 8.25% (from 5.25% Fed Funds Rate). In just over a year, rates jumped 5.00% or 500 basis points!
While the Unemployment Rate may be historically low (3.5%), this is typically a lagged economic indicator as the Conference Board’s Leading Indicator Index (a measure of ten other indexes or economic variables combined) is now firmly in the negative territory. On top of that, there have been three financial institution failures (Silicon Valley, Signature and First Republic) with a combined asset size of over $500 billion. There were thoughts that the Federal Open Market Committee might pause their rate hikes with these recent economic and financial market concerns. However, the FOMC opted to stay focused on its 2% to 3% annual inflation goal by raising rates another 0.25%.
The Federal Open Market Committee will meet June 13-14 to assess the state of the economy and the financial system. We’ll have to see if more policy work is needed to reduce inflation or if they raised interest rates enough to eventually satisfy their inflation goal. In addition, we’ll also see how the economic variables look through June to possibly determine where the economy is headed and if interest rates were raised too much to counter inflation. Then, if a recession does occur, how low will the FOMC go with cutting interest rates? 2003 proved they’ll go as low as 1.00%, but 2008 and 2020 proved they’ll cut as low as 0.25%. The markets have built-in rational expectations of what the Federal Reserve may do, as they may be expecting aggressive rate cuts if the economy does decline. Just look at the long-term Treasury bond yields, as the 5-year, 10-year, and 30-year bond rates are much lower than the higher short-term bond rates (3-month, 2-year). Short-term rates are typically lower than long-term rates.