The Federal Reserve (Fed) has recently emphasized the expectation that interest rates will remain “higher for longer.” That implies that even after the current cycle of rate increases, interest rates will stay elevated compared to what the Fed believes is necessary for sustaining economic growth, with inflation around 2%. The specific duration of “longer” has become a focal point of discussions among investors regarding the Fed’s future policy.
In its policy decision, the central bank announced that it would maintain rates of 5.25% to 5.5%, representing a 22-year high. Alongside this decision, the Fed released updated economic forecasts covering interest rates, unemployment, economic growth, and inflation, providing further insights into its outlook for the next three years.
Policymakers advocate for sustained rate hikes
In their recent speeches, Federal Reserve policymakers Governor Michelle Bowman and Boston Fed President Susan Collins expressed support for maintaining elevated interest rates. They emphasized the need for further rate hikes to combat persistently high inflation if economic data doesn’t cooperate.
Governor Bowman pointed out that progress in bringing inflation down to the Fed’s 2% target has been insufficient. She stated that she expects further rate hikes to be necessary to return inflation to the target promptly.
Boston Fed President Collins acknowledged that recent inflation data has improved, but she cautioned that it’s too soon to declare victory, especially considering elevated core inflation figures excluding shelter costs. She indicated that interest rates may need to remain higher and longer than previously projected, with the possibility of further tightening.
Despite not raising rates in their recent decision, Fed officials still anticipate one more rate increase this year and potentially two rate cuts in 2024, each at increments of 0.25 percentage points. Collins noted that while there are promising signs of inflation moderating and the economy rebalancing, progress has been uneven across sectors, and the effects of previous monetary policy moves may be taking longer to impact the economy due to the strong cash positions of consumers and businesses.
Both policymakers emphasized the Fed’s commitment to achieving its mandate while avoiding a recession and suggested that the path to achieving a soft landing for the economy remains viable.
Banks face a dilemma as deposits decline
When the Fed started raising interest rates in March 2022, banks held a record $19.9 trillion in deposits, thanks to the influx of cash from individuals and corporations due to Covid-era stimulus measures. However, they were not particularly concerned as cash flowed out of banks into money-market funds. That is because having too much in deposits can disadvantage some banks. Deposits are classified as liabilities, and having larger liabilities can necessitate banks to increase capital and face heightened regulation.
As a result, banks have not felt pressured to match the central bank’s aggressive interest-rate hikes. Commercial bankers argue that raising deposit rates to compete with money funds would compress their net interest margin—the difference between what they charge depositors and borrowers. They would need to raise loan rates to maintain profitability, which could tighten lending standards and potentially slow down economic activity, resulting in lower lending volumes.
Since March, banks have seen a nearly $700 billion decrease in deposits. There are indications that these outflows are starting to have an impact. Following declines in June and July, the largest U.S. banks increased their borrowing in August by 9%, or $70 billion, as per Federal Reserve data. Concurrently, the Federal Home Loan Bank System, a general liquidity provider for banks, witnessed an increase in total debt outstanding from $1.245 trillion in July to $1.249 trillion.
The rise in borrowing by major banks suggests that they are not comfortable letting reserves fall much further from current levels, wrote Citibank strategists Shuo Li and Jason Williams in a recent report.
Given the signals from Fed officials indicating that interest rates will remain elevated for an extended period, the outflow of cash from banks is expected to continue, placing them in a difficult position.
