The Fed raised rates by 75 basis points on Wednesday, following September's 8.2% inflation rate. Will Fed Chair Jerome Powell start to taper off the interest-rate hike cycle in December, or not?
In September, the economy added 263,000 new jobs as unemployment rates dropped back to their July level of 3.5%. After contracting in both the first and second quarters, GDP reversed to an annualized 2,6%. In September, consumer spending rose 0.6% despite inflationary pressures. The Fed was encouraged to maintain its rate of interest rate increases by the strong data. The Fed's interest rate strategy may change in December, but the business activity slowed for a fourth consecutive month.
A slowdown in the rate increase may be dependent on another, crucial factor.
The Fed's goal is to ensure maximum employment. This goal is also to prevent price volatility when inflation levels are cooling. As inflation began to be felt in March, the Fed pledged to increase interest rates at a rate that would reach a maximum of 4.75% to 5% by the end of 2023. This terminal rate is now higher.
The 25-basis point hike that began the current cycle of interest rates marked the end of an era of easy cash.
A tight money supply is not just about a higher rate of interest. The Fed rate must be higher than the inflation rate. The real interest rate is negative unless the Fed rate is higher than the Consumer Price Index.
The money supply is only tightened when the real rate of interest is positive. Since 2019, the real rate of interest has been negative. This has not changed, despite the fact that the Fed raised its target interest rate six times this year.
The Fed Fund rate will now be 3.75-4% after the 75-basis point hike on Wednesday. A further 50 basis-point hike in December will bring the Fed Fund Rate to 4.25%-4.5%. If the rate was raised by 75 basis points in December, it would be at 4.5%-4.7%.
In September, core inflation, which excludes volatile prices for food and energy, was 6.6%. This alone was higher than Fed's rate of 3% to 3.25% for the month.
What can we expect for 2023?
If the Fed's terminal rate is 5%, then the real rate of interest would be zero if the inflation rate drops to 5%. This will not result in a tightening of the money supply. Either the Fed rate must rise above 5% in order for real interest rates be positive, or the inflation rate must fall below 5% to be below Fed rate. It is important to achieve a crossover in order to have positive real rates, which will increase borrowing costs. The Fed raised rates between 2004 and 2006 from 1.25% up to 5.25%, before PCE fell to the 2% goal.
How far will the Fed push this time?
Real interest rates indicate that there is still room for the current cycle of rate increases. The good news is, this does not necessarily trigger a recession.
In 1980, when inflation reached 14%, the Fed's rate of 20% triggered a recession.
The connection between 2007 and 2008 is less clear. The Fed Fund Rate did indeed reach 5.25% right before the Great Recession of 2008. The subprime mortgage crises triggered the recession. In 1980, tighter monetary conditions fueled the recession rather than causing it.
Even a terminal rate as high as 5%, or even more, does not mean the economy will be in recession by 2023. A soft landing can still happen if pivoting is delayed rather than earlier.
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Investor's Business Daily published the post Why Powell's pivot depends on this simple math: The Fed rate just got hiked.