The Federal Reserve’s decision to hold rates steady signals that central bankers believe it is time to hit pause, at least temporarily, on their aggressive campaign to tame runaway inflation.
The latest data, not to mention several other factors, however, suggests it’s time for a full stop.
On June 14, 2023, the Fed chose not to lift rates for the first time in 11 meetings, leaving its target interest rate – a benchmark for borrowing costs across the global economy – at a range of 5% to 5.25%. Over 10 consecutive hikes beginning in March 2022, the Fed had raised rates a whopping 5 percentage points.
“Holding the target range steady at this meeting allows the committee to assess additional information and its implications for monetary policy,” the central bank said in a statement. The Fed indicated it still expects to raise rates two more times by the end of the year.
As an economist who follows the central bank’s actions closely, I believe there’s good reason to think the Fed’s brief hiatus is likely to turn into a permanent vacation.
Inflation is lower than it appears
The fastest rate of inflation since the 1980s is what prompted the Fed to hike interest rates so much. So it makes sense that inflation would be a key indicator of when its job is complete.
The latest consumer price index data, released on June 13, showed core inflation – the Fed’s preferred measure, which excludes volatile food and energy prices – falling to an annual rate of 5.3% in May 2023, the slowest pace since November 2021. That’s down from a peak of 6.6% in September 2022.
While the data shows inflation remains well above the Fed’s target of around 2%, there’s good reason to believe that it will continue to fall regardless of what the Fed does.
Shelter, a measure of the cost of owning or renting a home, is the largest component of the consumer price index, accounting for more than one-third of the total. In its latest report, the Bureau of Labor Statistics reported shelter costs rose 8% from a year ago. After stripping that out, inflation was up just 2.1%.
The thing is, the data reported by the bureau doesn’t reflect the reality of what’s happening in the current housing market.
The Bureau of Labor Statistics relies on a survey that gauges rental prices from 50,000 leases, many of which were signed during the rental bubble in 2021 and 2022. A better measure of current market rents is the Zillow Observed Rent Index. That index suggests rates are declining – rents rose 4.8% year over year in May, aligning with pre-pandemic rates.
Comparing the two measures suggests the official consumer price index data lags behind the market by four to six months. Using current rents would put inflation much closer to where the Fed wants it to be. Jason Furman, former chair of the government’s Council of Economic Advisors, created a modified version of core inflation – which uses a market-based measure of shelter prices – at 2.6%.
The risk of more rate hikes
Moreover, it is likely that further rate hikes will do more harm than good – particularly to the banking sector – and without helping lower inflation below its current trajectory.
Several regional lenders, including Silicon Valley Bank and First Republic, collapsed earlier this year following bank runs. Combined, they had over a half-trillion dollars in assets.
While there were several factors behind the banks’ demise, an important one was the Fed’s aggressive rate hikes, which caused the value of many of their assets to fall. The banks catered to depositors with accounts that exceeded the US$250,000 threshold protected by the Federal Deposit Insurance Corporation. These depositors ran for the hills when they learned about the extent of the bank losses.
Further troubles loom over the banking sector. In recent days, notable figures in the finance industry, such as Goldman Sachs CEO David Solomon and former U.S. Treasury Secretary Larry Summers, have warned that nearly $1.5 trillion in commercial real estate loans will require refinancing over the next three years.
The combination of already high interest rates and low office occupancy rates will likely force banks to absorb hundreds of billions of dollars in loan losses, inevitably putting more banks on the brink of failure.
And if the Fed keeps raising rates, the situation is likely to get a lot worse.
Don’t make the same mistakes
The Fed was behind the curve in 2021 and 2022 in realizing inflation was getting out of control, and it has been historically slow in recognizing the impact of rental rates on inflation.
The June pause in raising rates should give the Fed time to take a break, look at the data and, I hope, realize inflation is closer to its target than it appears.
But if it continues to raise rates, I believe the central bank will be repeating the same mistakes it made in the past.