The United States Federal Reserve makes a decision tomorrow and if you only watch one, watch this one.
There is a 97 per cent chance of a 25 basis-point hike by the Fed Wednesday, according to markets, but there are also growing odds that this will be the last.
A quarter-point hike would put the federal funds rate at 5 to 5.25 per cent, 500 basis points above where this particularly aggressive tightening cycle began 14 months ago.
So why would central bankers stop now?
BMO chief economist Douglas Porter argues that the 5 to 5.25 per cent range would put the rate just above the latest trends in U.S. core inflation and wages.
“Our contention for much of the past year is that short-term rates would need to at least rise above underlying inflation trends to truly break underlying inflation trends. And while core inflation looks sticky, it is now mission accomplished on the degree of rate rise,” he wrote in his weekly Talking Points.
Risk management is another argument for a pause, points out Oxford Economics. Banking turmoil, which continues to bubble up after the failure of Silicon Valley Bank two months ago, has tightened credit, which acts as a brake on the economy, essentially doing the Fed’s work for it. Financial markets are also starting to get nervous about America’s looming debt ceiling.
Most believe the Fed will signal that it believes monetary policy may be close to restrictive enough, but that further rate hikes cannot be ruled out, much as the Bank of Canada did when it paused earlier this year.
Market traders, who have been through a frantic 14 months, will rejoice at that news, but Desjardins’ Royce Mendes warns they might not want to break out the champagne just yet.
“Life after rate hikes isn’t always what it’s cracked up to be,” the head of macro strategy wrote in a recent note.
After rates peaked in the last three cycles, stock markets plummeted, the economy staggered and within nine months (on average) the Fed had to cut rates, he said.
“Simply put, the end of rate hikes often coincides with the beginning of more severe pain.”
The reason for this is that central bankers use rate hikes to slow growth and tame inflation, and they only stop when they think the economy has taken enough punishment. In fact, they are more likely to err on the side of too much, rather than too little, and that seems to be the case this time around, he said.
Some argue even higher rates are needed because the U.S. economy has proved more resilient than expected.
But Mendes says history has shown that rate hikes always take their toll and what looks like strength in the economy and financial system can quickly turn sour.
Take for example the year 2000 when the Fed hiked rates to 6.5 per cent. Forecasts at the time called for the U.S. economy to continue to grow in the following year, but almost immediately after the last hike, the S&P 500 reversed course, said Mendes. Over the next few years, the market tanked by almost 50 per cent and the jobless rate went up 2.5 percentage points.
“The end of this rate hiking cycle will imply that central bankers deem the outlook sufficiently gloomy,” said Mendes. “So whenever the Fed signals the end of this latest tightening campaign, traders might want to keep the champagne on ice because it might just be the beginning of a much more challenging environment.”