The Federal Reserve’s aggressive rate hike cycle may still have more room to run, even as inflation has cooled from 40-year peaks and banks significantly slow lending.
Consumer prices rose 4.9% year over year in April, down from the 9% peak in the summer of 2022, the Bureau of Labor Statistics reported on May 10. Meanwhile, banks reported a smaller appetite for new consumer loans during the first quarter of 2023 than at any point in nearly three years.
While cooling, inflation remains well above the central bank's 2% target, keeping future rate hikes as a distinct possibility. While access to credit has tightened and demand for loans has dipped in response to soaring interest rates and turmoil in the banking sector, the economy has yet to stumble enough to sway the Fed from keeping rates at the highest level in nearly 16 years.
"For now, the Fed is more focused on still-too-high inflation and the strongest labor market in decades as signs that the US economy continues to chug along at a consistent pace," Matthew Weller, global head of research with FOREX.com and City Index, said.
Lending tightens
During the first three months of the year, a net of 22.8% of banks surveyed by the Fed reported less willingness to grant consumer loans than a quarter earlier, according to data released May 8. This is down from a year earlier when a net 18.6% of banks reported an increased willingness to make new consumer loans.
The data from the Fed's quarterly senior loan officer opinion survey on bank lending practices shows credit from banks became harder to access as Silicon Valley Bank collapsed and distress spread throughout the sector. In addition, loan demand declined from firms of all sizes.
"There's been a significant tightening in credit standards over the past year and that is a headwind for the economy," said Joel Prakken, chief US economist with S&P Global Market Intelligence.
These tighter lending standards could have a similar effect to another interest rate hike, a point Fed Chairman Jerome Powell has made.
As banks become less willing to extend loans, aggregate demand is being constrained, potentially causing GDP to decline by 0.2% to 0.3% through the second half of this year, said Prakken.
When GDP declines, unemployment will likely inch up, causing inflation to decline. Yet the impact of tougher lending standards on inflation will not be substantial enough for the Fed, which has boosted its benchmark interest rate by 500 basis points since March 2022.
"It doesn't take future rate hikes off the table," Prakken said.
Sticky prices
Tighter lending could speed up inflation’s move back to 2% as consumers have less ability to borrow to keep spending high.
"This will accelerate the downward momentum in the coming months," said Gregory Daco, chief economist for EY-Parthenon.
Rate hikes, however, have yet to deal a massive blow to the US labor market, which continues to add hundreds of thousands of jobs each month as wages keep climbing.
"The economy at large is still chugging along," said Callie Cox, a US investment analyst at eToro.
And while prices are rising at a much slower rate than the peak in June 2022, inflation has proven sticky, particularly in services. Fed Chair Jerome Powell on May 3 signaled the central bank may push rates higher if inflation remains high. The Fed’s own economic projections call for rates to remain at their current peak through the end of the year.
Inflation is "persistently elevated at intolerable levels," Prakken with Market Intelligence said, and will likely prevent the Fed from abandoning potential plans to hike rates more.
"They're clearly not there yet," Prakken said.