Federal Reserve Raises Interest Rates by 25 Basis Points, Opens Door to Pause

Federal Reserve Board Chairman Jerome Powell delivers remarks at a news conference following a Federal Open Market Committee meeting in Washington on May 3, 2023. Anna Moneymaker/Getty Images

The Federal Reserve raised interest rates by 25 basis points on May 3, lifting the benchmark federal funds rate to a range of 5 percent to 5.25 percent, the highest level since September 2007.

The vote to raise rates by a quarter-point was unanimous, according to a statement from the Federal Open Market Committee (FOMC).

Markets had mostly priced in a rate increase, so investors were more focused on forward guidance than the May policy decision.

The post-meeting statement opened the door to a rate pause, with the removal of the line, “The Committee anticipates that some additional policy firming may be appropriate.”

“In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments,” the Fed stated.

Futures markets are now showing that traders are pricing in a pause at the June FOMC meeting and then a cut in September.

On the banking front, the Fed reiterated that the “banking system is sound and resilient,” adding that tighter credit conditions will likely “weigh on economic activity, hiring, and inflation.”

“The extent of these effects remains uncertain,” the post-FOMC meeting statement reads.

“Economic activity expanded at a modest pace in the first quarter,” the FOMC stated. “Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated.”

Stocks traded slightly higher following the Fed announcement, with the leading benchmark indexes rising by about 0.2 percent. However, during Chair Jerome Powell’s post-FOMC press conference, stocks turned negative on concerns about elevated interest rates.

“Here we are, deep into this rate hike cycle where they now are backed into a corner, weighing the risk of high inflation versus a banking calamity that we have been going through,” Ken Mahoney, the CEO of Mahoney Asset Management, said in a note. “We knew they would raise rates until they broke something, and they certainly have broken the regional banking sector.”

Inflation Battle, Banking Turmoil

Despite investors penciling in a rate cut, Powell told reporters during the post-meeting news conference that such a move “would be inappropriate” because inflation is taking longer to subside.

“Inflation has moderated somewhat since the middle of last year. Nonetheless, inflation pressures continue to run high, and the process of getting inflation back down to 2 percent has a long way to go,” Powell said. “Despite elevated inflation, longer-term inflation expectations appear to remain well anchored as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets.”

But the Fed will need a few more months of data to accomplish and maintain “a sufficiently restrictive stance” in its inflation battle.

“It will take some time, and in that world, if that forecast is broadly right, it would not be appropriate to cut rates, and we won’t cut rates.

“In principle, we won’t have to raise rates quite as high,” he added.

The worst of the banking turmoil appears to be over, Powell noted.

The financial institutions that were at the heart of the banking stress in March—Silicon Valley Bank, Signature, and First Republic—“have now all been resolved,” and depositors have been protected. So, with this resolution and the sale of First Republic Bank, Powell said he believes that this period of severe stress has diminished.

However, he noted that the macroeconomic effects emanating from the banking crisis will be monitored carefully moving forward.

On the issue of a recession, Powell disagreed with Fed economists that the United States will face a mild recession later this year.

Powell acknowledged that he feels “this time is really different,” noting that there is “so much excess demand.”

“It’s interesting, as you know, we’ve raised rates by 5 percentage points in 14 months, and the unemployment rate is 3.5 percent, pretty much where it was—even lower than where it was—when we started,” he said.

“The case of avoiding a recession is, in my view, more likely than that of having a recession,” Powell told reporters, adding that he doesn’t rule out having a downturn either.

“It’s possible that we will have what I hope would be a mild recession.”

A Call to Pause

With First Republic Bank failing—the third bank failure since March—a chorus of experts had urged the Fed to hit the pause button on its tightening cycle heading into the much-anticipated meeting.

Paul Donovan, UBS’s global chief economist, told Bloomberg on May 3 that he “wouldn’t be hiking” if he were running the Federal Reserve.

Former Dallas Fed Bank President Robert Kaplan also told the business news network that the central bank should do “a hawkish pause,” citing the banking turmoil that he said he believes is in the early stages. This policy maneuver would leave interest rates unchanged but also “signal that we’re in a tightening stance.”

U.S. lawmakers also had recommended that the Fed refrain from pulling the trigger on higher rates.

Ten senators and representatives, led by Sens. Elizabeth Warren (D-Mass.) and Bernie Sanders (I-Vt.), warned in a letter to Chair Powell warning that an “overreaction” would leave the economy “vulnerable” to a recession “that destroys jobs and crushes small businesses.”

The public also wanted the Fed to stop raising rates.

A recent Lake Research Partners poll found that 56 percent of U.S. voters thought the central bank needs to stop hiking rates.

“Our new poll makes it clear that people across the country want the Federal Reserve to stop raising interest rates before it pushes us toward a devastating and completely avoidable recession,” said Rakeen Mabud, chief economist at the Groundwork Collaborative.

The Fed’s tightening campaign has affected consumers’ wallets, according to new research from WalletHub.

The personal finance website’s recent Fed Rate Hike Survey found that nearly 70 percent of Americans reported their finances taking a hit because of higher interest rates, and 46 percent said the Fed’s rate hikes will affect their summer plans.

Economists projected that a quarter-point increase would cost credit card users an additional $1.7 billion in the next 12 months. Overall, the 500-basis-point spike in the Fed funds rate since March 2022 is expected to cost consumers with credit card debt about $33.4 billion over the next 12 months.

“In fact, the 25-basis-point rate hike expected on May 3 has already increased the cost of the average 30-year mortgage by roughly $11,600, given that rate hikes are usually priced into mortgage rates in advance,” WalletHub analyst Jill Gonzalez said.

Recession Concerns

In recent months, economists have asserted that the Fed is stuck between a rock and a hard place on interest rates. If Powell keeps raising interest rates, he might exacerbate the banking turmoil and trigger a recession. On the other hand, if he hits the pause button, he could enable the reacceleration or stickiness of inflation.

But critics have claimed that all three events are happening anyway.

Since March, there have been three bank failures. Moreover, there are fears that there could be more small and midsize bank collapses in the coming months, contributing to the sharp selloff in regional bank stocks. PacWest Bancorp, for example, has fallen about 43 percent in the past week on deposit flight concerns.

In the first quarter, personal consumption expenditure (PCE) prices climbed to 4.2 percent, and core PCE, which strips the volatile food and energy sectors, advanced to 4.9 percent. The annual PCE price index eased to 4.2 percent in March, but the core PCE slowed to a higher-than-expected 4.6 percent.

In addition, the employment cost index rose 1.2 percent in the first three months of 2023, up from 1.1 percent in the fourth quarter and higher than the market estimate of 1.1 percent.

That a recession is coming has become the consensus of many economists, policymakers, and market analysts.

“Versus the market, we are less sanguine that inflation is going to come down, and more certain that we are entering a recession and risk assets are priced too richly for that outcome,” Mimi Duff, the managing director at investment management firm GenTrust, wrote in a research note. She added that there is no expectation for the Fed to employ rate cuts this year.

Fed economists anticipate a recession later this year, according to minutes released from the March FOMC meeting.