Those lessons about interest rates need reworking
Investors can probably take the Fed's word on US interest rates being near their peak. Image Credit: Gulf News

It is a sobering fact that at the Federal Reserve’s latest interest rate meeting, they raised interest rates to 5 per cent, the highest level seen since the Global Financial Crisis of 2008.

The Fed indicated they hope interest rates are very close to their peak. However, should we even believe the Federal Reserve’s forecasts? It is good to have a measure of scepticism when assessing any interest rate forecast from the Fed.

Each year for the past three years, the Fed has become less confident about its projections and has been increasingly wrong. The Fed’s views are an aggregation of views across the membership of the Federal Open Market Committee (FOMC). The breadth of those forecasts has been getting wider and wider.

Take the most recent set of interest rate forecasts for the end of 2024; the range of forecasts is from 5.75 per cent down to 3.37 per cent, and for 2025 from 5.75 per cent to 2.25 per cent.

Fed’s short of fixes

The Fed is in a fix. A situation it hasn’t been in since the 1970s and early 1980s. Inflation is running so hot that it is even above the unemployment rate.

The Fed has a dual mandate of price stability and full employment. Economists generally agree that price stability is crucial and full employment desirable. Hence, the Fed has set its interest rate policy to control any inflation and laterally set interest rates to bring about full employment.

Most famously, between 1979 and 1987, with Paul Volker at the helm of the Federal Reserve, the FOMC increased interest rates to 19 per cent even though the policy led to a peak unemployment rate of close to 11 per cent. By 1986 the Fed funds rate was down to 1 per cent and unemployment 6.8 per cent.

If life wasn’t difficult enough, the Fed now has to contend with the challenges of the mini-banking crisis. Fed chair Jay Powell has characterised the recent bank runs on regional banks such as Silicon Valley Bank, Signature Bank, and First Republic as what, in essence, was a tightening of monetary policy.

Deposits withdrawn from regional banks (who tend to lend strongly to the economy) have ended up in the larger banks, which have less propensity to lend. At the whole economy level, this leads to a net reduction of lending and, in effect, a tightening of monetary conditions, which is bad for growth.

The negative impact of the latest banking crisis is the equivalent of 25-50 basis points on interest rates.

The last element of the debate about where interest rates go from here is quantitative easing or money printing. When the Fed stepped in to save Silicon Valley bank and others by depositing cash with them, they were increasing the size of their balance-sheet and adding money into the monetary system – a form of easing equivalent to cutting interest rates.

To summarise a complicated outlook for interest rates in the US and the dollar-pegged currencies of the Gulf, the most likely outcome is that interest rates will likely peak between 5-5.5 per cent assuming US inflation trends down through the balance of the year.

However, for some quarters, prepare for interest rates to stay at around the 5 per cent level until global growth slows and inflation is on a clear downward path.