Source: Golden Ten Data

For those worried that record interest rate hikes might put too much pressure on the banking system or trigger a recession due to widespread credit crackdowns that would cause businesses and households to default, the Federal Reserve's latest financial stability report is good news, because none of this happened.

Instead, the Federal Reserve is struggling to cope with an economy that has been freed from tight monetary policy, so much so that Fed officials have no clear view of what will happen in the future, and disagree on issues such as productivity and the potential potential of the economy. They don't even know whether the current policy interest rate is as restrictive as they think.

Interest rate cuts seem certain to begin in early 2024, but now it seems that they will have to wait at least until September, as inflation remains high.

A wave of credit crunch seems to have come and gone. Bank loans are growing, corporate credit spreads are shrinking, household balance sheets are generally healthy, the economy is still growing at a higher rate than potential, and jobs are increasing. The recent update of the US Federal Reserve's Overall Financial Condition Index shows that the current monetary policy of the Federal Reserve or its intention to influence the broader credit situation has had little impact on economic growth.

Contrary to the assessment made by Federal Reserve officials that the policy is restrictive, the current credit situation in the economy “is in line with higher-than-trend growth.” Joe Kalish, chief global macro strategist at Ned Davis Research, believes that this means that the transmission of US monetary policy to the real economy is “far less effective than other countries.”

Federal Reserve officials themselves aren't sure whether they still need an economic slowdown to reduce inflation, or whether the “perfect” effects of productivity and other factors will work. This is an important issue because one view favors tighter policies and the other favors looser policies.

Key inflation data released on Friday is expected to show that the Fed's preferred inflation target is still far above its 2% target, which may be a sign that anti-inflation progress has stalled.

Under such circumstances, the Federal Reserve may claim to rely on data, but it mainly relies on “intuition” and “instincts” to determine whether the US has found a new balance of high growth and low unemployment, or whether more pressure is needed to ensure that inflation is mitigated.

Ed Al-Hussainy, senior analyst at Threadneedle Investments' global interest rate and currency team, said, “The Federal Reserve does not have a clear framework for inflation, nor a clear set of parameters to evaluate policy positions. It is really difficult for them to express the judgment that 'policy is restrictive'.”

In recent years, an unexpected increase in immigration has supported America's labor supply, and a partial slowdown in globalization and the redistribution of consumer spending to the service sector continue to drive inflation.

Unlike the austerity era in the past, the real estate market has not succumbed to high interest rates and has been driving inflation recently. Concerns about the impact of large federal deficits on financial markets have been revived, and unresolved questions about productivity and “neutral” interest rates used to guide policy tightening.

What is puzzling is whether America's economic potential is higher than expected; it is possible to achieve continued strong growth without high inflation, or whether growth in recent years has been boosted by a series of “temporary” shocks, such as the Trump administration's tax cuts, or federal transfers and infrastructure spending under Biden, which could mean faster inflation and higher interest rates.

Joseph H. Davis, the world's chief economist at Pioneer Group, said in a recent study that federal debt and an aging population have pushed up neutral interest rates by one percentage point, which means that the Federal Reserve's policy is not as tight as one might think. This will help explain current economic growth, but it will also make reducing inflation more difficult.

Davis said, “If you reduce the scope, you'll find more and more evidence that monetary policy isn't as strict as the Federal Reserve thinks.” He currently predicts that the Federal Reserve will not cut interest rates at all this year. “You can infer from financial conditions, labor markets, and inflation. Neutral interest rates are all higher.”

Federal Reserve officials now say they will continue to wait to see if the current 5.25%-5.50% interest rate range will return inflation to the target level of 2%, and will not consider further increases in policy interest rates. Since the Fed's policy meeting next week is likely to keep interest rates unchanged again, observers will look for some clues from the Federal Reserve's latest statement or Federal Reserve Chairman Powell's press conference to understand the direction of the situation.

Powell was probably the first to admit that he was beginning to be uncertain. Luke Tilley, chief economist at Wilmington Trust, said, “At some point, they kind of abandoned the idea that they could predict inflation and economic trends.”

edit/lambor