U.S. Federal Reserve Chairman Jerome Powell arrived on Capitol Hill in Washington, D.C., on March 6, 2024, to testify at a hearing held by the House Financial Services Committee on the “Federal Reserve Semiannual Monetary Policy Report.”
Mandel Yan | AFP | Getty Images
With the economy booming and the stock market, despite some recent bumps, still in good shape, it’s hard to believe that rising interest rates will have a significant negative impact on the economy.
So what happens if policymakers decide to keep rates on hold for longer and not cut rates throughout 2024?
Even in its current form, the issue still sends shivers down Wall Street and unnerves Main Street.
“When rates start to climb, you have to adjust,” said Quincy Krosby, chief global strategist at LPL Financial. “The calculation has changed. So the question is, if rates stay higher for an extended period of time , will we encounter problems?”
A longer-term higher stance wasn’t what investors expected at the start of 2024, but it’s what they have to contend with now as inflation proves stickier than expected, hovering around 3% compared to the Fed’s 2% target .
Recent statements from Fed Chairman Jerome Powell and other policymakers have reinforced the view that interest rates will not be cut in the coming months. In fact, there is even discussion that if inflation does not ease further, there may be one or two further rate hikes in the future.
That leaves some big questions: When exactly will monetary policy ease, and what impact will the central bank’s continued on-foot stance have on financial markets and the broader economy.
Crosby said some of those answers will soon be revealed as the current earnings season heats up. Company executives will provide key details beyond sales and profits, including the impact of interest rates on margins and consumer behavior.
“If there’s any sense that companies are going to have to start cutting costs, causing the labor market to struggle, then there are potential problems with interest rates that high,” Crosby said.
But despite the S&P 500’s recent decline of 5.5%, financial markets have largely held up amid rising interest rates. Even with the Fed on hold, the large-cap index is still up 6.3% year to date and 23% above its low in late October 2023.
Higher interest rates could be a good sign
History has mixed opinions on the impact of a hawkish Fed on markets and the economy.
Higher interest rates are generally a good thing as long as they are related to economic growth. That wasn’t the case last time, when then-Federal Reserve Chairman Paul Volcker deliberately pushed the economy into recession by aggressively raising interest rates to curb inflation.
There is little precedent for the Fed cutting interest rates during a period of strong growth such as this, with gross domestic product (GDP) expected to accelerate at an annualized rate of 2.4% in the first quarter of 2024, which would mark the seventh consecutive quarter of positive growth. at 2%. Preliminary first-quarter gross domestic product data will be released on Thursday.
At least in the 20th century, it was difficult to make the argument that high interest rates caused recessions.
Instead, the Fed chairman is often accused of keeping interest rates too low for too long, leading to the dot-com bubble and the subprime mortgage market collapse that triggered two of the three recessions this century. On the other hand, when the economic downturn caused by the new crown epidemic occurred, the Fed’s benchmark funds rate was only 1%.
In fact, some believe there is too much focus on the Fed’s policies and their broader impact on the $27.4 trillion U.S. economy.
“I don’t think aggressive monetary policy will have nearly as much of a boost to the economy as the Fed thinks,” said David Kelly, chief global strategist at J.P. Morgan Asset Management.
Kelly pointed out that in the 11 years between the financial crisis and the new crown pandemic, the Fed tried to use monetary policy to increase inflation to 2%, but mostly failed. Falling inflation has coincided with tightening monetary policy over the past year, but Kelly doubts the Fed has much to do with it.
Other economists have made a similar point that the main issue that monetary policy affects – demand – remains strong, while supply issues that largely extend beyond interest rates have been the main driver of the slowdown in inflation.
Kelly said interest rates do matter to financial markets and, in turn, economic conditions.
“Interest rates that are too high or too low distort financial markets. In the long run, this ultimately harms the economy’s productive capacity and can lead to bubbles that destabilize the economy,” he said.
“I don’t think they set interest rates at the wrong level for the economy,” he added. “I do think interest rates are too high for financial markets and they should try to get back to normal levels — not low levels, but normal levels — and stay there.”
The higher and longer the possible path
Kelly said that as a policy issue, this would mean a three percentage point cut in interest rates this year and next, bringing the federal funds rate to a range of 3.75%-4%. That’s broadly consistent with the 3.9% rate by the end of 2025 that FOMC members pictured in their “dot plot” forecast last month.
Futures market pricing implies that the federal funds rate will be 4.32% by December 2025, indicating a higher interest rate trajectory.
While Kelly advocates “gradual normalization of policy,” he does believe the economy and markets can tolerate permanently higher interest rates.
In fact, he expects the Fed’s current forecast of a “neutral” interest rate of 2.6% to be unrealistic, an idea that is gaining traction on Wall Street. For example, Goldman Sachs recently argued that the neutral rate (neither stimulus nor restriction) could be as high as 3.5%.Cleveland Fed President Loretta Mester also recently said it was possible The long-term neutral interest rate is higher.
That tilts expectations for Fed policy toward a slight cut in interest rates, but not a return to the near-zero rates that prevailed in the years after the financial crisis.
In fact, over the long term, the federal funds rate has averaged 4.6% since 1954, even though the federal funds rate has been near zero for seven consecutive years since 1954. 2008 crisis Until 2015.
government spending issues
However, one thing that has changed dramatically over the decades is the state of public finances.
Since the outbreak of the COVID-19 pandemic in March 2020, the national debt of $34.6 trillion has surged, increasing by nearly 50%. The federal government is projected to run a $2 trillion budget deficit in fiscal 2024, with net interest payments expected to exceed $800 billion due to rising interest rates.
The deficit will be 6.2% of GDP in 2023; by comparison, the EU only allows its member states 3%.
Troy Ludtka, senior U.S. economist at SMBC Nikko Securities America, said fiscal generosity has stimulated the economy enough to make the Fed’s interest rate hikes less noticeable, which would be a problem if benchmark rates remain high. This situation may change in the coming days.
“One of the reasons we haven’t noticed this monetary tightening simply reflects that the U.S. government is pursuing the most irresponsible fiscal policy in a generation,” Lutka said. “We are running huge deficits in a full-employment economy, which It really keeps things afloat.”
However, even as sales remain steady, higher rates are starting to take a toll on consumers.
Federal Reserve data shows that as of the end of 2023, the credit card delinquency rate climbed to 3.1%, the highest level in 12 years. Lutka said higher interest rates could cause consumers to “retrench” and ultimately create a “cliff effect” where the Fed would eventually have to back down and lower interest rates.
“So, I don’t think they should be cutting rates in the near future. But at some point, that’s got to happen because these rates are just going to crush particularly low-income Americans,” he said. “That’s a large portion of the population.”
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