Opinion: Where does the Fed go from here?

Don Davis

For more than a year, the Federal Reserve has been waging a war against stubbornly high inflation, which has been raising the cost of living for Americans. The U.S. central bank’s strategy has been to tighten the money supply in the economy through a series of interest rates hikes designed to slow economic activity and eventually lower prices.

It’s a tightrope walk for the Fed: Tighten too little and keep inflation elevated for a longer time as it attempts to engineer a soft landing of the economy or act too aggressively and risk pushing us into a recession, or a hard landing.

So, how did we get here, and where are we headed?

Policy matters
In the decade leading up to 2020, the Fed supported the U.S. economy by keeping interest rates incredibly low. This policy created a healthy U.S. money supply – the total sum of currency and other liquid assets flowing through the economy – and allowed businesses and consumers seeking credit easy access to it.

Then the COVID-19 pandemic and subsequent lockdowns hit in 2020. The U.S. economy whipsawed from a position of relative strength to a recession within the span of about 30 days.

At the onset of the pandemic, the federal government, including the Fed, pumped trillions of dollars into the system to buoy the economy. This fiscal medicine worked but with a significant side effect: too much stimulus that led to inflation, which started to rise in late 2021.

By spring 2022, inflation rates surged to levels not seen in more than 40 years. The Fed’s response was to enact an aggressive strategy of raising its federal funds rate – the interest rate charged by the Fed to banks and other lending institutions on funds borrowed overnight.

Since March 2022, the Fed has hiked interest rates nine consecutive times, raising the federal funds target rate essentially from 0% to a range of 4.75%-5% today.

Wait for it
Is it working? Unfortunately, it’s too early to tell. Inflation, as measured by the consumer price index, moderated from its peak of 9.1% in June 2022 to 5% in March. It’s an improvement but still far higher than the Fed’s 2% inflation target range.

And there could be unintended consequences. It typically takes 12 months for the full effect of a single rate increase to work its way through the U.S. economy. Given the Fed has made nine rate increases in just over a year, it will take some time for us to realize the full impact of this strategy.

One thing is certain: The economy, is cooling. Activity in the manufacturing and service sectors, as measured by the purchasing manager’s index, has contracted five straight months. Commodity prices have fallen on items like raw materials and oil.

Soft or hard landing?
The U.S. labor market has fluctuated some, though the unemployment rate remains around 3.5%. But keep this in mind: Employment is a very coincident indicator to recessionary conditions. In other words, by the time jobs are declining significantly on a regular basis, it’s likely the economy is already in a recession.

The Fed has indicated it’s near the end of its rate hiking program, with another increase possible in May.

Commerce Trust believes the Fed will follow through on the increase and then keep rates steady for the near term as the economic cycle plays out.

Whether or not the Fed achieves a soft or hard landing is still in play. Stay tuned.

Don Davis is a senior portfolio manager for Commerce Trust Co. in Springfield. He can be reached at don.davis@commercebank.com.