The Fed’s Challenge: Has It Hit the Brakes Hard Enough?

When the Federal Reserve began sharply raising interest rates two years ago, the prospect of mortgage rates hitting 7% terrified Dwight Sandlin, a home builder based in Birmingham, Ala. “I was scared to death. Scared. To. Death,” he said.

He just booked his most profitable year ever.

While sales of his modern farmhouse-style homes have dipped since the postpandemic frenzy, profits are strong because a shortage of existing homes for sale has propped up prices.

“The market is still very firm—not great, but firm. And there’s only one reason: There ain’t enough inventory,” said Sandlin. “If you can’t make money in the home-building business right now, you need to go do something else.”

The Fed meets this week to decide whether, when and by how much it should cut rates later this year. A key question it must answer: Just how tight is its monetary policy? Not very tight, judging by the experience of builders such as Sandlin and consumers’ overall resilience. For Fed officials, that argues against cutting rates much, or soon, especially after two months of firmer-than-expected inflation.

On the other hand the federal-funds rate target, at 5.25% to 5.5%, is relatively high in nominal and inflation-adjusted terms, and there are signs the economy’s current strength won’t last—a point Chair Jerome Powell has hinted at. If so, then monetary policy might soon start to look tight, reinforcing the case for cutting.

A key gauge of inflation, which excludes volatile energy and food prices, has fallen below 3% in recent months from nearly 5% early last year.

Two feet on the brakes—or just one?

Because of lags, the question of whether growth perseveres or rolls over in the face of past interest-rate hikes might well be resolved in the next six months.

The Fed raises short-term interest rates to cool inflation by slowing demand, hiring and wage growth. It does that through the ripple effects on broader financial conditions such as stock prices and long-term bond and mortgage rates. The interest rate that achieves financial conditions that keep the economy at full strength and inflation steady is called “neutral.” To slow growth and reduce inflation, the Fed must push rates above neutral.

Some business executives, economists and Fed officials say solid growth suggests rates might not be that far above neutral right now.

“We thought we had two feet on the brakes, but maybe we in fact only have one foot on the brakes, and that’s why we haven’t seen as much of a reduction in demand,” Minneapolis Fed President Neel Kashkari said.

Pandemic-driven idiosyncrasies blunt higher rates

When Covid-19 hit four years ago, the government showered the economy with cash and the Fed pushed interest rates down to near zero. Businesses and consumers locked in those low rates, dulling the initial effect of the Fed’s rapid tightening two years later.

Thanks to more recent government spending on infrastructure and green-energy projects, “you haven’t seen the normal shedding of construction jobs that you should have” with higher rates, said Eric Rosengren, former president of the Boston Fed.

No sector illustrates the postpandemic resilience to high rates as much as housing. Historically, it is the most important channel through which Fed tightening slows the economy. To be sure, sales of existing homes have tumbled.

But prices haven’t fallen because many Americans who locked in low mortgage rates are staying put, as are many who have no loan since there is so little to buy. Some home builders are offering buyers somewhat below-market interest rates on new homes, offsetting the full hit from Fed hikes for their buyers.

“This is a property market that wants to recover,” said Ray Farris, an economist based in New York. “This thing is a loaded spring.”

Higher housing prices and a stock market up nearly 20% since November are boosting wealth and thus supporting consumption, especially of high-income households. The price of bitcoin has recently surged to records, a sign of exuberant risk-taking.

In addition, banks that turned more cautious over the last two years in anticipation of a recession could open up lending spigots. Bond issuance has been strong this year.

“Find me a place where you can’t borrow money,” said Farris. “The debt markets in the United States and in Europe are completely open,” for both investment and speculative-grade companies.

Evidence of tighter policy

But there are reasons to think 2023’s surprisingly brisk 3.1% growth doesn’t capture how tight monetary policy really is. Powell has suggested that growth isn’t a result of demand but instead reflects a burst of supply from higher immigration and more people entering the workforce. “That won’t go on forever,” he told reporters on Jan. 31. “When that peters out, the [monetary] restriction will show up, probably, more sharply.”

Some economists say as long as interest rates stay as high as they are now, the economy will face a drag from households and businesses that must devote more income to interest expenses.

They point to other pockets of weakness. Commercial real-estate values have tumbled and delinquency rates on office-backed loans jumped in December to 5.8%, the highest since late 2017, according to S&P Global. Delinquencies on apartment-backed loans are also creeping up.

Surveys show banks are pulling back from consumer lending. Interest rates on credit cards are near record highs and credit-card delinquencies are rising. Retail sales in January and February were soft.

“You have to look at whether banks are willing to continue making loans to consumers, and the data suggests they’re not quite as keen as they were a year ago or two years ago,” said Peter Berezin, chief global strategist at BCA Research in Montreal.

Household savings buffers for lower-income consumers, built up during the pandemic thanks to restrained spending and government relief, also appear to be exhausted. Bank deposits and money-market funds are below prepandemic levels when adjusted for inflation for all but the 20% most affluent households, said Berezin.

Consumers spent heavily the past few years because “they had money in their pockets,” said Philadelphia Fed President Patrick Harker. “For consumers of lower-to-moderate income, they’ve burned through that. It is gone, and they are struggling. That’s why they’re loading up on credit-card debt.”

Ian Borden, chief financial officer at fast-food giant McDonald’s, said last week that more consumers are eating at home instead of dining out now that those savings buffers are gone.

And executives at Lennar, the nation’s second-largest home builder, said last week that more prospective buyers in recent months were struggling to qualify for a loan because they had too much debt.

While job growth is strong and unemployment stable, the number of open jobs is declining and wage growth has slowed, which both point to cooler demand for labor.

The share of small businesses planning to add jobs fell to 12% in February, the lowest since the pandemic, according to the National Federation of Independent Business.

Outside of hiring for government and healthcare, “it’s been pretty flat,” said Harker. “That starts to give me a little concern.”

The challenge of unscrambling conflicting signals explains why officials are focusing on what happens with inflation. If inflation continues to move lower, “you could say, ‘Why keep rates where they are?’” said Kashkari, the Minneapolis Fed president. But if the economy is expanding solidly, it is fair to ask “why do anything?”

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