What Happened When the Fed Raised Rates?

Hike in May and stay away. - After raising interest rates by 25 basis points at the May meeting, the Federal Reserve hinted that it might stop there. The question is whether this round of rate hikes has been enough or too much. Given the Fed's ongoing efforts to rebalance credit tightening and inflation pressures since the banking crisis, the Fed sent the following signals at this meeting:

First, the Fed tends to think it has raised enough rates, as credit tightening can replace rate hikes to curb demand and inflation. Therefore, this meeting no longer retains the "some additional policy tightening may be appropriate" rate forward guidance, and Powell later said at the meeting that "in principle, we don't need to raise rates so high," echoing this point.

Second, the possibility of further rate hikes is not zero. Although rates are already at restrictive levels, Powell said that "the Fed is continuing to assess whether rates are sufficiently restrictive" due to high inflation and steady employment, and he gently refuted the market's pricing of recent rate cuts, stating clearly that "if inflation remains high, we will not cut rates."

Third, the impact of credit tightening on the macroeconomy remains to be seen. While large bank deposit flows have stabilized, the Fed acknowledges that the overall situation in the banking industry has improved, but because bank loan standards and terms have further tightened since the banking crisis, the Fed still needs some time to assess the lagging effects of credit tightening on the domestic economy (Figure 1-2).

It can be seen that, similar to most previous pauses in rate hikes, the Fed's attitude this time is still "reserved" (Figure 3).

Now that the rate hike has come to an end, the market's focus is undoubtedly on how far away we are from "cutting rates" from "pausing rate hikes"? To this end, we examined the eight scenarios since 1980 in which the Fed paused rate hikes and began cutting rates (Figure 4).

As shown in Figure 5, based on the different contraction effects of previous rate hikes on the economy, the reasons for rate cuts are mainly divided into two types: preventive rate cuts and crisis rate cuts. And there are also differences in the distance from pause to rate cut under these two different reasons.

One is a preventive interest rate cut after enough tightening, as the contraction effect is limited and the economy has not declined, the interest rate cut is also limited. The purpose of preventive interest rate cuts is to hedge against the downside risks of the economy in a timely manner. The time from suspending interest rate hikes to interest rate cuts is short, and the interest rate cut is small. In 1995 and 1997, not only did interest rate cuts begin 5 months after suspending interest rate hikes, but the interest rate cut was only 0.75%.

In 1995, it was always used as a template for the Fed's "preventive interest rate cut" and cut interest rates 5 months after suspending interest rate hikes. Although the Mexican financial crisis caused signs of weakness in the US economy, it still remained in a healthy growth range, increasing the Fed's policy space. The Fed seized the opportunity to cut interest rates preventively when the economy had not yet clearly slowed down. Finally, it successfully achieved a soft landing.

The other is a crisis interest rate cut after too much tightening in the early stage, which exacerbates economic imbalances. As shown in Figure 6, the Fed made emergency and substantial interest rate cuts before the recession. The main reason behind the crisis interest rate cut is the structural imbalance of the economy, followed by the arrival of the recession in the next 3-4 months. In this case, the time from suspending interest rate hikes to interest rate cuts is long, and the interest rate cut is large.

The 2007 financial crisis is a typical representative, and interest rate cuts began 15 months later. In the early stage, monetary tightening was excessive, and the supply and demand of the real estate market continued to be imbalanced. After the bubble burst, it triggered a major recession. Then, interest rates were substantially cut to zero.

Overall, the Fed generally "actively lays out" in the scenario of "enough tightening" and "passively makes up for it" in the scenario of "too much tightening". Therefore, the former is less than the latter in the time of suspension and the subsequent interest rate cut. Specifically, interest rate cuts usually begin about half a year after suspending interest rate hikes (Figure 7). From the perspective of the degree of interest rate hikes in the early stage, if it is enough, interest rate cuts usually begin after an average of 5 months. But if it is caused by too much tightening, the time from suspension to interest rate cuts is an average of 8 months.

Compared with the current overall situation in the United States, it is more similar to the first scenario. Although the market consensus that the recession will begin in the second quarter is heating up, under the benchmark scenario, the recession is unlikely to occur in the next 3 months. First, the labor market is stable, and the momentum of consumption recovery is still continuing; second, the long-term interest rate has fallen below 4%, driving down mortgage rates, and the real estate market is stabilizing; third, the contagion of the banking crisis is insufficient.

According to previous reports, this time it is a liquidity problem and has not triggered credit risk. Taking into account the above three reasons, the risk of recession within the year is limited. However, it is worth noting that the current inflation pressure has not been resolved for a long time, and the suspension time this time will be longer than the historical average. Therefore, it will support the Fed to maintain interest rates "longer and more persistently" after this interest rate hike. The recession and interest rate cuts may be postponed to 2024.