As expected, the Federal Reserve held rates steady at the September 19-20 policy meeting, following 11 hikes over the last 18 months that lifted short-term rates from near zero to a range of 5.25- 5.50%. The jury is still out as to whether the central bank has reached the end of the rate-hiking cycle aimed at wrestling inflation down to its 2% target, a level that prevailed over most of the 20 years before the post-pandemic inflation surge got underway. As hard as it is to remember, a major concern during that pre-pandemic period was the difficulty of getting inflation up to at least 2%, an effort that, not coincidentally, underpinned the low-interest rate environment that had prevailed since the 2008 financial crisis.
Just as the tame inflation and low interest rate environment of the pre-pandemic years seems like a distant memory, the last two years of elevated inflation and high interest rates are seen by many as a permanent feature of the U.S. economy. That would be a mistake.
For sure, it’s highly unlikely that we will see “free money” again any time soon, as it would take a lot of economic pain and strong deflationary forces for the central bank to drive interest rates down to zero again. But evolving trends strongly indicate that the Federal Reserve is near, if not at, the end of hiking rates, and the economy is near, if not at, a tipping point that will lead to a significant slowdown, if not an outright recession.
Granted, on paper the economy headed into the fourth quarter looking far more robust than expected a few months ago. Earlier in the year most economists and traders believed that the U.S. would be sliding into a recession by now, and the Fed would be cutting rates. The consensus view was that the combination of the rapid rate hikes since early 2022 and high inflation would be too much for the economy to bear, prompting consumers to pull in their horns and businesses to lay off workers. When several large regional banks failed in the spring, creating a mini financial panic, recession fears surged, cementing that doomsday conviction. But businesses and consumers hardly blinked, as the former kept expanding payrolls and the latter kept on spending. Instead of slowing, data for the just concluded third quarter is tracking a 3% growth rate, which would be even stronger than the 2% over the first half of the year. But that tracking rate is misleading, as it is all front-loaded into July, when households were still flush with pandemic savings and prices were rising faster than costs, boosting corporate profits. Since then, activity has downshifted, and the economy is facing a rough patch in the final months of the year. A soft landing is still a possibility – and indeed has gained a lot of adherents in recent months — but we remain skeptical that the Fed can successfully bring that about.
Why Rate Hikes Didn't Do More Damage
Despite the downbeat sentiment early this year, the economy powered through the myriad hurdles that seemed insurmountable, most notably the rapid climb in interest rates, high inflation and the financial turmoil following the bank failures in the spring. Forecasters were hard-pressed to explain why these headwinds failed to have more of a growth-retarding impact than they had. In hindsight, some of the reasons now seem obvious.
Take, for example, the failure of sky-high interest rates to deter consumer spending, which was the biggest driver of growth over the first half of the year. One reason higher borrowing costs didn’t stifle purchases is that households retained a bulwark of formidable spending power — the $2.1 trillion of excess savings built up during the pandemic. Hence, even as job growth and wage gains slowed over the first half of this year, households tapped into this cushion of savings to sustain spending. Those drawdowns more than compensated for the slowdown in income growth this year.
For another, the inflation that made goods and services more expensive for everyone decelerated much more quickly than wage growth this year. Indeed, for most of this year wage gains outpaced inflation, restoring worker purchasing power; by midyear, inflation-adjusted earnings had finally exceeded the level prevailing just before the Covid recession started. Finally, households took steps to insulate themselves from the interest rate surge by locking in the low rates prevailing before the Fed started tightening the screws. They also used a big chunk of their stimulus checks to pay down debt early in the post-pandemic recovery. Debt repayments as a percent of incomes have been rising in recent quarters but are still comfortably below historical levels.