So, things really are different this time. The Federal Reserve Bank decided to raise its Federal Funds Rate on May 3 by a quarter-point, to 5.00-5.25 percent, in spite of a banking crisis that has seen three large banks fail in the space of six weeks, with remarkably little spillover into the economy at large. The misery mostly limited to shareholders in the banks concerned. This is where rates sat before the financial crisis hit in 2008.
This recent rate hike has caused plenty of controversy as fears grow that further hikes risk tipping the economy into recession. The inflation rate sat at 5 percent on the year in March, but core inflation (which excludes fuel and food) slightly increased in March, up to 5.6 percent. So, the Fed raised rates once again, in an effort to get price hikes under control, reiterating their focus on dragging inflation back down to earth even if it means tipping the economy into recession.
It should be noted that unemployment fell to 3.4 percent last month, matching the lowest reading since 1969. So far, historically high inflation, slowed economic growth, increasing interest rates and banking turmoil has not cracked the still hot labor market.
For the past two decades, this sort of thing didn’t happen. Under the unwritten laws of the “Greenspan put”, the Fed could be relied upon to provide some form of stimulus at the first sign of financial trouble. It began with the collapse of the hedge fund Long Term Capital Management in 1998, when the Fed put together a $3.6 billion bailout funded by a consortium of banks, and it carried on long after former Fed chair Alan Greenspan himself had departed the scene.
Greenspan argued with monotony that “free markets are inherently self-regulating”, (like foxes are inherently the best guardians of chickens). If markets wobbled, if banks got into a spot of trouble, an interest rate cut, or quantitative easing was never far behind. He took the Fed in a direction quite different from the previous ruling guideline expressed by William McChesney Martin, Fed Chairman from 1951 to 1970, who’s famous for supposedly having said: “The Fed’s job is to take the punch bowl away just when the party’s going good”. Or words to that effect.
Investors formed an expectation that the Fed would always help. It was an Alice in Wonderland world where bad economic news often became good—good because investors calculated that the Fed would respond with a stimulus package. By such means, the country ended up with the bubble economy of the past 20 years.
But this time around, the Fed has failed to oblige. True, until the collapse of the Silicon Valley Bank, the Fed had been expected to raise rates by half a percentage point compared with the quarter point increase announced May 3. But by raising rates at all the Fed has signaled that yes, it really did mean it when it said it was going to tackle inflation. Not even falling US inflation has persuaded the Fed to take a break from its tightening program. The Fed officials have said they want to see sustained evidence that inflation is moving toward their 2 percent goal.
The Fed finds itself in a tricky situation, having failed to act on price rises early on, so now they are playing catch up. They were too late to the game to keep prices under control—having suffered a hit to credibility, have had to keep hiking rates, putting a damper on economic growth. The Fed is clearly hoping this is the end of the line.
It softened its language in its statement after the May 3 hike, no longer preparing investors for further rate hikes, but rather noting that a myriad of factors—including economic growth—would feature in the “extent to which additional policy firming may be appropriate”. In other words, interest rates may still rise, but it is by no means certain. Ergo, only a naïve or ignorant person who say the worst if over.