Fed hikes key rate, sees tighter credit

The US Federal Reserve today raised its target interest rate by a quarter point, in line with expectations, even as it sees recent banking stresses helping in its bid to combat inflation.

The Federal Open Market Committee (FOMC) raised the federal funds target rate by 25 basis points, the second such increase in a row.

The Fed's 2023 projection for its target rate, called the federal funds rate, remained at a median of 5.1pc, unchanged from December, a sign the Fed may be nearing the end of its course of rate increases. The projection, known as the dot plot, is derived from expectations of board members and Fed bank presidents.

"If we need to raise rates higher, we will," Fed chairman Jerome Powell said in response to a question regarding the dot plot federal funds projection.

"For now, we see the likelihood of credit tightening" because of banking stresses, Powell said. "In a way, that substitutes for rate hikes."

The second consecutive quarter point hike followed a 50-basis point hike in December that came after four consecutive 75-basis point hikes earlier last year. The string of rate increases has taken the target rate to a range of 4.75-5pc from near zero at the beginning of 2022 in the most aggressive tightening since the 1980s.

The FOMC said it anticipates that "some additional policy firming may be appropriate" to return inflation to its 2pc target "over time" — adding "some" to the language used in prior statements.

The slowing pace of rate increases comes as authorities in Europe, North America and Asia take steps to stem the banking crisis that has upended financial markets and sent oil prices to a 15-month low. Swiss bank UBS on 19 March agreed to take over Credit Suisse for $3bn after depositors pulled funds from the bank in the wake of spreading contagion triggered by the prior week's failure of Silicon Valley Bank and a smaller bank in the US. The Federal Reserve led a group of central banks on 19 March to boost dollar swap lines to ensure global liquidity, following a 12 March statement assuring additional funding to eligible depository institutions to meet the needs of all depositors.

"The US banking system is sound and resilient," the FOMC said of the this month's banking crisis. "Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation."

Tighter credit conditions

Goldman Sachs wrote in research this week that the tighter lending standards resulting from the banking stress would subtract between a quarter to a half percentage point from GDP growth in 2023, equivalent to the impact of a 25-50 percentage point of tightening of the fed funds rate.

Goldman Sachs had predicted the Fed would pause rate hikes as it said Fed officials would consider the stresses to the banking sector a greater threat than inflation. It added that the banking stress could also have disinflationary effects.

The Fed's latest rate hike comes as inflation has eased from last year's highs amid mounting signs the economy is slowing. US manufacturing has contracted for four months, home construction and purchases have cooled and retail sales have fallen in three of the last four months. While technology companies like Amazon have announced mass layoffs in recent weeks, the labor market remains solid, with unemployment near five-decade lows.

By raising the federal funds rate, an inter-bank overnight lending rate whose effects ripple across consumer and business lending rates, the Fed undermines demand for big-ticket items like cars, homes and equipment to rein in pricing pressures.

The US consumer price index in February rose by 6pc on an annual basis, the lowest since September 2021 and down from a 9.1pc peak in June that was the highest since 1981.

By Robert Willis