Here's why markets are looking forward to the first pause in rate hikes by the US Fed since Jan 2022

‘The skip’ is how Wall Street refers to it. The US Federal Reserve appears to be hinting that it may be prepared to temporarily suspend – or miss – raising interest rates in its two-day review that begins on Tuesday (June 13) after ten consecutive rate hikes over the previous 15 months.

Investors are hesitant to refer to this anticipated rate action as a “pause” since markets appear to be pricing in the possibility that this likely pause in the Fed’s ongoing rate hikes won’t last. However, if there is a pause, even a little one, it may indicate that the Fed is likely to shift its emphasis away from the American labour market as a crucial indicator of economic health.

Given that both inflation and the job market continue to be far more resilient than anticipated, US stock investors, who just a few weeks ago were betting that the Fed would likely start cutting rates in the coming months, now anticipate that the benchmark short-term rate set by the US central bank, which serves as the peg for the majority of consumer and business loans in the US, will likely remain high for the rest of the year. But a few remarks made by Fed Chair Jerome Powell over the past month give weight to this assumption of a skip.

Powell stated on May 19 that it was “still unclear if US interest rates will need to rise further” as central bank officials “balance uncertainty about the impact of past hikes in borrowing costs and recent bank credit tightening” with the fact that inflation is proving difficult to manage. Powell was interrogated by a staff member from the US central bank at a research conference, and Powell made a rehearsed comment in which he claimed that bank officials “can afford to look at the data and the evolving outlook to make careful assessments.”

Powell had dropped another hint only a little more than a week earlier. “In the future, we’ll use a data-dependent methodology to assess if further policy firming may be necessary… But it appears that the difficulties in the banking industry that surfaced in early March are making it increasingly harder for people to get loans for their homes and companies. These more restrictive loan conditions will undoubtedly have an impact on inflation, hiring, and overall economic growth. The scope of these consequences is still unknown. He stated at a Federal Open Market Committee meeting on May 3 that in view of these ambiguous headwinds, together with the monetary policy constraint we’ve implemented, our future policy measures will depend on how things develop.

Since then, numerous additional Fed officials have reaffirmed that they would be willing to watch the incoming data. While the US jobs report continues to come in stronger than predicted, another crucial component is the consumer price index report, which is anticipated to be released later on Tuesday. Furthermore, with meetings of the Bank of Japan, the European Central Bank, and the People’s Bank of China scheduled for later this week, the Fed’s view may set the tone for central bank activity for the remainder of the week.

Despite losing support, some people still believe that a walk is an option. The effects of the several rate hikes on the US banking industry are one of the causes. In an opinion piece published in The Wall Street Journal earlier this month, Kevin Maxwell Warsh—who was a member of the Federal Reserve Board of Governors from 2006 to 2011 and is currently a visiting fellow at the Hoover Institution—discussed the effects of the Silicon Valley Bank collapse and argued that, absent a change in policy, the US banks might experience a slowdown and require even more government assistance. Warsh has pushed for “using this moment to protect ourselves and protect the banking system” a lot.

Powell mentioned the state of the US banking industry in a statement he released on May 3 and claimed that “conditions in that sector have broadly improved since early March and the US banking system is sound and resilient.” “We’ll keep an eye on the industry’s conditions. We’re determined to draw the appropriate conclusions from this experience. And we’ll endeavour to stop similar incidents from occurring again.

Regarding monetary policy, Powell stated that the Fed’s priority “remains squarely on our dual mandate to promote maximum employment and stable prices for the American people”. In addition, he stressed that the Fed will “take a data dependent approach in determining the extent to which additional policy firming may be appropriate” even though he and his colleagues “understand the hardship that high inflation is causing and we remain strongly committed to bringing inflation back down to our 2% goal”.

What do these data points represent? As a result, the real GDP growth rate in the US was 0.9% last year, which was much below average. The first three months of this year’s calendar saw continued modest economic growth of 1.1%. Additionally, despite an increase in consumer spending, activity in the US housing market remained poor, mostly due to increasing interest rates and mortgage rates. Business fixed investment appears to be suffering from slower production growth as well. And the labour market activity, which is the most crucial statistic, is still rather tight.

The job increases during the first three months of 2023 averaged 345,000 jobs per month, which is a very impressive performance, and the unemployment rate stayed extremely low in March at 3.5%. However, the sustained strength of the US labour market presents a challenge for policymakers in Washington when it comes to developing an efficient response. The labour market’s inability to soften had fueled the US central bank’s decision to tighten monetary policy more aggressively in the past.

However, Powell made it a point to emphasise that “there are some signs that supply and demand in the labour market are coming back into better balance” as well as that “nominal wage growth has shown some signs of easing and job vacancies have declined so far this year” in his speech on May 3. However, generally, there is still a significant labour shortage, which the Fed has been trying to alleviate before putting the brakes on its rate-hiking binge.

While a robust economy and the ongoing strength of the American labour market give President Joe Biden a boost as he prepares for his reelection campaign, there is some concern in political circles that the high interest rates may negatively affect borrowers and smaller businesses more. further significantly, any worsening of the banking crisis might reduce optimism even further and have an effect on Biden’s chances. Therefore, if the Fed decides to skip or pause, there is a greater probability that the economy will decline gradually, leading to a soft landing rather than falling suddenly into recession. The more difficult the landing, the worse it would be for Biden’s chances of winning reelection.

The US Fed conducts monetary policy similarly to other central banks, such as the Reserve Bank of India, and largely affects employment and inflation through employing tools to manage credit availability and costs in the economy. The main monetary policy tool that central banks employ to combat spikes in inflation is an increase in interest rates. Since borrowing money costs more when interest rates rise, households are less likely to spend money on products and services, and businesses are less likely to borrow money to grow, purchase machinery, or invest in new ventures. 

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