Most investors and Wall Street research analysts believe the Federal Reserve will pause its hikes, keeping the benchmark interest rate unchanged, in June and that a rate cut is likely later in the year.
Just take one look at the yield curve. It is still inverted with the one-month rate higher than the six-month or 12-month rate. With the banking industry still reeling from several regional bank failures, the financial system appears to be fragile and a rate pause would be prudent.
But they may be underestimating the risk of still higher rates.
Fed officials in their May meeting laid the groundwork for a rate pause in June but stopped short of committing to it. That has convinced investors that a pause is coming, but economic data and some experts suggest that rate hikes are still necessary, and the central bank may enact another 25-basis point increase in June.
In addition, systemic risks may force rates higher yet, regardless of Fed actions next month.
The consensus carefully managed by Fed Chair Jerome Powell over the past year appears to be breaking.
There is reason for the Fed to be hawkish. Inflation today is still more than double the central bank’s target. Dallas Fed President Lorie Logan, who is a voting member of the Federal Open Market Committee, noted that economic data “could yet show” that an interest rate is necessary.
This sentiment for more monetary tightening is based on evidence that the U.S. economy remains stable enough to ward off a severe recession for the time being.
For example, the labor market remains tight. Individuals filing new claims for unemployment benefits fell more than expected last week. In 15 states, unemployment rates are now at all-time lows. And in the rest of the states unemployment remains steady and in general very low. Of course, parsing the data shows much of the growth is in the service sector, but nevertheless, the headline numbers don’t currently support a drastic Fed policy shift.
Some of the more interest rate-sensitive sectors of the economy that had been impacted by recent policy tightening—specifically the U.S. housing market—appear to be weathering the storm fine for the moment.
Permits for new single-family home construction rose to a seven-month high in April. While high interest rates and a relative capital markets freeze have made it more difficult for homebuilders to obtain financing, the optimism for construction means builders don’t expect pricing to soften dramatically.
The National Association of Home Builders/Wells Fargo Housing Market index rose this month to 50 for the first time since July 2022, when the recent housing market contraction began.
Mortgage rates have also softened, although they remain high compared to recent norms. The average rate on a 30-year fixed-rate mortgage declined from a peak of 7.1 percent in November to 6.4 percent according to Freddie Mac data.
A recent study by the San Francisco Fed shows that American households are sitting on half a trillion dollars’ worth of excess savings. That’s a staggering amount of cash and is enough to maintain current spending levels into next year, the central bank branch report noted.
“The consensus across the [Fed] speakers was broadly that non-housing services inflation has shown no signs of significant improvement while the labor market has slackened only marginally, but views on how the Fed should react were less uniform,” Morgan Stanley economists wrote in a note to clients. “On net, during the course of the week investors interpreted the Fedspeak as leaning hawkish and market pricing for a 25bp rate hike in June moved up to ~40%.”
However, the bank still does not believe that a June hike is likely—effectively, Powell turned dovish.
“Then came Chair Powell. On Friday he delivered carefully scripted responses that avoided commenting on near-term policy, but nevertheless seemed to tilt away from the need to hike further.”
One of the reasons Powell believes benchmark rates might not need to rise as high as the Fed had originally planned is because of recent banking industry turmoil. The regional banking crisis has effectively curtailed bank lending regardless of interest rates and serves as a proxy for the Fed’s monetary tightening.
Another argument for not raising rates is the ongoing debt ceiling negotiations in Washington. If Congress and the White House cannot agree and a technical default is declared or the Treasury Department invokes the 14th Amendment to issue through the debt limit, there are ramifications. Uncertainty will push rates higher. Investors will demand more interest for the same risk.
Even if any defaults are quickly resolved, there are still negative impacts. Rating agencies could deliver a downgrade of U.S. debt, similar to S&P’s downgrade on U.S. debt in 2011, despite a debt resolution.
In 1979, the Treasury missed an interest payment that was quickly rectified, but T-bill yields still jumped 60 basis points and remained elevated for months. All of these events could permanently increase borrowing rates for the U.S. government as well as businesses, banks, and the broader public.
In one way or another, the probability of interest rates increasing next month is greater than investors’ expectations.
