New York, Dusseldorf America’s central bankers would have liked clearer signals. But the US economy continues to be so inconsistent that the Fed could be forced to raise interest rates further. Inflation in the United States fell significantly in March to 5.0 percent from 6.0 percent in February.
But at the same time, core inflation, which is important for the Fed, rose from 5.5 to 5.6 percent. Core inflation eliminates volatile prices such as energy and food. It was the first time in over two years that core inflation was above the headline inflation rate.
The drop in inflation, “while notable, has a lot to do with the fact that we are comparing today’s energy prices to the initial spike in energy costs after the Russian invasion of Ukraine in February 2022,” said Olu Sonola, an economist at Rating Agency Fitch .
The central bankers are therefore faced with a difficult task. On May 3, you will decide on the further interest rate strategy. A further increase of 0.25 percentage points is considered likely, but by no means a foregone conclusion. The Fed had hiked interest rates at a record pace over the past 12 months to the 4.75 to 5.0 percent range to combat inflation.
However, after three regional banks in the USA collapsed in March, the Fed can no longer concentrate solely on fighting high prices. The central bank must now also keep an eye on financial market stability and should not underestimate the risks on the capital markets, warns Diane Swonk, chief economist at KPMG. “Financial crises tend to develop in spurts and are often dismissed at first, even when they have reached critical stages,” Swonk argues. It is therefore important to closely monitor the aftermath of the recent market turbulence. At the beginning of the financial crisis in 2008, many central bankers underestimated the extent of the problems.
The Fed is far from there in its fight against inflation
Above all, the bankruptcy of the Silicon Valley Bank (SVB) brought the negative consequences of the interest rate hikes for the banks into focus. The bonds in the portfolio of the Californian money house caused high book losses, since the rising interest rates weighed on the valuation of the bonds.
After the SVB collapse, the Fed launched a new lending program that now allows banks to pledge their bonds as collateral at face value rather than market value. With this support measure for the banks, the Fed wants to separate the fight against inflation from its efforts to stabilize the financial markets. “However, this separation is difficult to achieve,” warns Swonk, who also advises the Fed. “Rapid rate hikes are always destabilizing.”
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The Fed is also far from there when it comes to fighting inflation. Housing costs continued to rise in March, albeit at a slower pace than in previous months. This factor contributed “by a large margin” to the monthly increase in prices, according to the Labor Department. The prices for plane tickets, restaurant visits and various insurance policies also continued to rise. Conversely, food prices fell for the first time since September 2020. Used car prices, a key factor in US inflation calculations, also fell.
“Inflation is moving in the right direction, but overall levels are still too high,” says Fitch’s Sonola. Derek Tang, an economist at analyst firm LH Meyer in Washington, also expects the Fed to hike interest rates by a quarter of a percentage point in May. It is conceivable that the Fed could then pause interest rates.
In mid-March, the Fed raised US interest rates by 0.25 percent. The next interest rate decision, which the markets are eagerly awaiting, is due in early May.
(Photo: Reuters)
Investors initially reacted positively to the weaker inflation data. In New York, the Dow Jones leading index posted moderate gains, as did the Nasdaq technology exchange.
The probability of another rate hike fell shortly after the data was released on Wednesday. Currently, only a good 60 percent of traders still expect the Fed to raise interest rates further. Before the inflation figures, it was still 74 percent, according to data from the derivatives exchange CME Group. But professional investors have repeatedly been wrong with their interest rate expectations in recent months.
There are also different opinions about future monetary policy among the central bankers in the USA. John Williams, head of the regional Fed in New York, said on Tuesday that interest rates should be raised again as the central bank must continue the fight against inflation.
The head of the Fed in Chicago, Austan Goolsbee, on the other hand, called for “caution and patience” from his colleagues. One must first observe the effects of the banking crisis and the much tighter credit conditions. There is great uncertainty about how the problems in the financial sector will develop. “So we should be careful,” Goolsbee said.
Fed Chair Jerome Powell left all options open after the last interest rate decision in mid-March. Further rate hikes may be appropriate but are not guaranteed.
Rising interest rates increase the risk of a recession
Further rate hikes would also increase the likelihood of a recession and further market turbulence. Torsten Slok, chief economist at the private equity investor Apollo, is already talking about a “credit crunch, the beginnings of which we are currently observing”.
The situation is particularly tense on the market for office properties in the USA. With the ongoing work-from-home trend, office demand has fallen significantly across the United States. Especially the already ailing regional banks keep a large part of these loans on their books.
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Slok expects a recession that will force the Fed to change strategy. The central bank could lower interest rates again this year in order to cushion the consequences of a downturn.
The stock markets could also become turbulent in the coming months if interest rates continue to rise.
Wells Fargo equity strategist Chris Harvey expects the broad S&P 500 index to suffer a 10 percent correction over the next three to six months. That would take the index down to around 3700 points, which is close to the November lows.
So far, stocks have been surprisingly resilient, Harvey said. But the gloomier economic outlook, “driven by aggressive monetary policy and potential capital and liquidity problems sparked by the banking crisis,” would put pressure on equity valuations.
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