The Federal Reserve needs to stay put on rates

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The author of this blog post possesses prior experience as the head of the Federal Deposit Insurance Corporation in the United States and currently holds a distinguished position as a senior member at the Center for Financial Stability.

The decision of the US Federal Reserve to halt the increase in interest rates during its recent policy-setting meeting should be considered justified. However, it appears that they are now inclined to resume raising the rates. Pardon the expression, but this action could potentially turn a winning situation into a loss. Currently, it would be wise for the Fed to maintain its current stance and keep the interest rates unchanged.

The increasing heat caused by climate change could be contributing to extremely hot weather conditions, but the rate of inflation in the United States is decreasing. In June, the consumer price index only increased by 3 percent, a significant drop from its highest point of 9.1 percent in June 2022. The rate at which producer prices are rising has also significantly slowed down.

Persistent rises in the expenses of housing and amenities have notably decelerated. Additionally, an independent examination carried out by Morgan Stanley utilizing fresh rental contract information reveals that residential rental charges have genuinely decreased in certain instances. Furthermore, the economy continues to thrive, with the unemployment rate standing at a mere 3.6 percent. The month of June welcomed the addition of 200,000 novel employment opportunities.

These patterns offer optimism that inflation can be significantly decreased, or even overcome, without causing harm to the economy, as long as the Federal Reserve avoids going beyond the necessary measures.

In the last 15 months, the Federal Reserve has increased interest rates rapidly. They have raised rates from almost nothing to over 5 percent. As of April, the measure of money supply called M2 has decreased by 4.6 percent compared to the previous year, which is the largest decrease since the Federal Reserve started officially tracking M2 in 1959. The economy requires some time to adapt to these significant changes in monetary conditions, especially considering that the Federal Reserve maintained near-zero interest rates for 14 years.

The economy appears to be adapting - at least for now - but there are still many uncertainties to come. Several trillions of dollars in corporate and commercial real estate have yet to be adjusted to higher rates, but they will need to be refinanced over the next few years. Although households still have the advantage of cash reserves accumulated during the pandemic, they will start experiencing the full impact of increased interest rates once those funds run out. Although the job market is still strong, the growth of private sector employment has noticeably decelerated.

The labor force and small enterprises are especially vulnerable if sudden hikes in interest rates lead to more banking troubles. This, in turn, places additional strain on local and communal financial institutions.

The main emphasis of the Federal Reserve on increasing rates in the short term has caused an unusual situation in the market known as "yield curve inversion". In this scenario, the costs of borrowing in the short term are actually higher than the long-term rates. If this continues, it poses a serious danger for smaller banks whose profits rely on utilizing short-term deposits to offer longer-term loans at higher rates.

If the Fed chooses to increase rates once more – which appears likely in this week's gathering of the policy-making Federal Open Market Committee – it may soften the effects by solely increasing rates on bank reserves. Meanwhile, the rate paid to money market funds and other non-bank financial intermediaries would remain unchanged.

With the aid of recently acquired tools granted by Congress in 2008, the Federal Reserve now has the capability to enhance the interest rates it offers to banks on their reserve accounts in times when it intends to elevate rates. Consequently, this provides banks with a motivation to retain their reserves at the Federal Reserve, unless they can generate a greater, adjusted-for-risk profit by lending them elsewhere.

In the year 2013, the Federal Reserve established an "overnight reverse repo facility" without the approval of Congress. This facility operates like a reserve account for entities other than banks, such as money market funds. It offers interest rates that are almost as high as the rates paid on bank reserves. This also encourages non-banks to retain their money at the Federal Reserve, without it being actively used.

Although initially intended to be restricted and short-term, the ONRRP has unexpectedly expanded into a colossal $2tn program, causing financial insecurity as it depletes funds from banks.

Reducing the interest rate on ONRRP compared to the Federal Reserve's target rate is expected to prompt money market funds to shift a portion of their funds away from the program and towards investments that support our economy's credit requirements. As a result, this would alleviate the negative effects of a rate increase, while simultaneously promoting bank stability as the redirected capital would flow back into bank deposits.

The Federal Reserve is currently confronted with challenging decisions ahead. However, it is crucial to acknowledge that if they opt for additional tightening measures, there is an increased likelihood of both a recession and financial instability. In the event that they do proceed with tightening, they must actively seek ways to minimize its negative consequences. In a similar vein to how the Federal Reserve incorrectly gauged the inflation risks associated with its loose monetary policies, it should not underestimate the potential ramifications of the astonishingly rapid pace at which it is currently tightening. Ultimately, the safest option would be for the Federal Reserve to maintain its current stance and refrain from making any further adjustments.