Fed pauses rate hikes; soft landing or year-end recession still up in the air

Interest rates: Ahhh! The pause that refreshes…but for how long?

The Federal Reserve finally eased its 15-month-long assault on inflation by holding the benchmark fed funds rate steady at a range between 5 and 5.25 percent at its June 13 - 14 meeting. The Fed cited modest expansion of economic activity, robust job gains and low unemployment, but cautioned that inflation remains high.

The pause will likely be short-lived, according to Kiran Kini, CoBank senior vice president and treasurer. Kini says the Fed is preparing the market for two additional rate increases over the remainder of the year.

“The Fed is trying to get ahead of the markets right now,” Kini said. “The burden is on economic data to talk them out of further hikes. We think there is an intent to hike maybe one more time and be done, but given how exuberant the market has been, they don't want to risk it. Absent significant improvement in the data—which they might see—they will look to hike in July and one more time after that.”

Kini pointed to some positive developments in economic data, which could indicate that core inflation will come down further. Still, it’s a bit of a mixed bag, especially when considering the services sector.

“Used car prices and rents have come down, which should help reduce core inflation,” Kini said. “But core services inflation has remained sticky, which is what the Fed is watching. For now, it's going to stay sticky. 

“The turning point is likely to come in the fourth quarter when student loan payments restart, which will put a drag on consumer balance sheets and cash flows,” he continued. “We expect things to really begin to slow down later this year when the tailwinds we’ve had turn to headwinds and the higher rates finally start to bite.” 

Kini said a fourth quarter recession remains a possibility, but a much-desired soft landing—where economic growth continues throughout the rate tightening cycle—is not out of the question.

The pause might provide some refreshment after all.

It isn’t all about the rates…

While interest rate hikes take what is expected to be a very short-term pause, other factors are playing into the economy and capital markets activity.

According to PitchBook, a Morningstar subsidiary focused on private-equity and M&A activity, the odds of a recession occurring in the next 18 months continue to rise, driven primarily by a sharply inverted yield curve and an increase in short-term interest rates. These two signals are at their most extreme levels since the 1980s. The possibility that high inflation will persist creates a risk that short-term rates will remain above 5 percent well into 2024.

Also, credit conditions have tightened further following a period of stress within regional commercial banks. This will likely constrict loan growth and increase spreads for middle-market companies and, in turn, nonresidential corporate investment (also see the Power & Energy update below).

“These factors are at the center of why lenders are visibly pulling back from their borrowers,” said Bill Fox, managing director, Capital Markets at CoBank. “PitchBook’s recessionary outlook is shared by many, but it has not put the brakes on the support we have for our customers. The benefit that CoBank provides is that, unlike many other lenders, we are open for business. We remain supportive, even providing incremental capital in some cases while others are pulling back.”