Understanding the Federal Reserve can have profound effects on markets and our financial lives; that’s why understanding its decisions is of such critical importance.
Investors hoping for a smoother economic recovery and lower interest rates have put their faith in the Fed’s so-called dot plot, and will face an important test on Wednesday.
Economists Expect a Bumpy Ride
Investors’ primary concerns will likely include inflation, jobs and the Federal Reserve’s aggressive tightening policies. “If interest rates rise despite stable employment and inflation levels, bond markets could eventually experience their day of reckoning,” wrote Khalaf.
A central bank aims for a “soft landing” when raising interest rates to slow the economy and combat inflation; raising them too significantly may cause recession or hard landing, which would require it to happen gradually rather than suddenly.
As the economy attempts to rebound from its coronavirus-driven recession, economists anticipate an uneven recovery with some sectors slowing while others rebounding; overall though, economists anticipate less dramatic recovery trends compared to past recessions due to lagged policy effects and consumers tapping vast savings accounts. This episode of Economic Lowdown podcast examines business cycles as well as the role that Federal Reserve plays in smoothing them out.
The Fed Bets on a Smooth Landing
The Federal Reserve seeks to achieve a “soft landing.” They aim to manage an economic slowdown without sending the economy into recession; key indicators being unemployment rates which should grow slowly but steadily and inflation rates which don’t surge unexpectedly.
There is no official definition of a soft landing; however, Princeton economist Alan Blinder suggests it would have been achieved when GDP declines by less than one percentage point and NBER does not declare recession within one year of Fed rate increases. Jerome Powell seems confident his central bank can work magic and secure such an outcome.
Others remain less confident. Investors like Bill Ackman have voiced concern that an increase in rates could accelerate deposits leaving regional banks, increasing the risk of hard landing. Still, most professional forecasters predict unemployment will fall below 5% by 2023 while inflation will return towards its goal of approximately 2%.
The Fed’s Next Move
CME Group’s FedWatch tool predicts that investors have an 88% chance of the Federal Reserve maintaining current stance by pausing interest rate hikes instead of hiking them, even though economic conditions have yet to fully adjust to higher borrowing costs.
But, transition to Powell-led Fed is fraught with difficulty. Three members of the Board of Governors and several Regional Bank Presidents (Yellen included) stepped down this year, altering its top leadership.
As such, this may explain why the Federal Reserve has taken an exceptionally cautious approach to raising rates this year. As policymakers approach year’s end, they remain mindful of last fall’s financial tightening that saw mortgage rates spike past 8% and 10-year Treasury yields surge close to 5%; henceforth yields have seen some relief after initially increasing significantly; although 2024 will put our economy’s resilience to test.
The Fed’s Final Words
As opposed to most government officials, the Fed chair enjoys exceptional power over markets in near real-time. Markets react instantly when he speaks as spokesperson for his central bank and negotiates with Congress and executive branch; there is no accepted mechanism that allows a president to remove him or her, thus giving him unprecedented autonomy.
Powell’s comments gave investors confidence that the Federal Reserve wasn’t planning any further rate increases and were willing to allow inflation overshoot for now. Yet he signaled to officials that financial conditions weren’t restrictive enough in order to combat high inflation effectively.
The Fed can impact economic activity through monetary policy, which influences the availability and cost of money and credit. They’ve used trillions in asset purchases to bolster financial markets. Their current goal should be reducing inflation without leading to recession requiring further rate hikes.