The Fed Hikes Rates, But The Path Ahead Remains Uncertain

The recent volatility in the banking sector has put the Federal Reserve at a crossroads, where it must balance financial stability against inflation. Greg Bonnell speaks with James Marple, Senior Economist at TD, about the path ahead and the clouded economic outlook facing the Fed.

Transcript

Greg Bonnell: Of course, the US Federal Reserve raised interest rates by 25 basis points. Other global banks making similar moves in its wake. And that comes, of course, as policymakers are also dealing with a wave of banking turmoil. So signals out there that it may be near the end of their hiking cycle? Let's talk about all that.

Joining us now with his view, James Marple, senior economist with TD. James, great to have you back on the show. We are still sifting through, I guess, the aftereffects of what we got from the Fed. What was your read?

James Marple: Well, I thought they made the right decision ultimately. I think the market had been anticipating 25 basis points, and they delivered on that. There was some speculation they would pause given some of the turmoil we've seen in financial markets. But interesting, before all of the recent events with SBV and whatnot, there was even expectations they'd go as much as 50.

And certainly, the economic data that has come in at the start of this year would have warranted some of that. I mean, we've seen both job growth come in well above expectations and sort of well above the pace you'd expect given where the unemployment rate is, but also seen inflation that remains stubborn and something that they're trying to get to 2%. More hikes would have been on the table, but offset, obviously, by what we've seen in terms of the banking sector.

Greg Bonnell: Yeah, it seems like the collapse of Silicon Valley Bank (SIVB), Signature (SBNY), the worry about some of the US regionals definitely had them dial back that tough talk. Because the tough talk was only two weeks ago. I mean, that was when Jerome Powell was in Washington saying maybe we needed to go further than expected on rates, putting 50 on the table. And all of that got dialed back. And now the market is trying to figure out if they're done or not.

But yet as you said, the economic conditions-- we got some jobless numbers this morning. And the labor market is still tight in the States. This seems to be a pretty tough road ahead for the Fed.

James Marple: Yeah, well certainly, that was even reflected in both the statement and in the chairman's press conference afterward where he really stressed the uncertainty that the Fed themselves face, but all economic forecasters face, in the current environment. I mean, trying to figure out how much this tightening and financial conditions-- how much, probably, now will be a tighter lending standards, especially among some of these smaller banks that have been under pressure, what that will mean to the real economy. And there just isn't a lot to go by on that.

I mean, we can try to obviously look at historical correlations. But in many ways, this is kind of unprecedented, certainly in the speed at which things have happened and just given all the changes that have happened in the financial sector over the next decade. So it is a little bit of a guessing game.

But I think we can say that when financial conditions are tightened and when lending standards are tightened, it tends to result in less loan growth, less demand, and less economic activity, in some sense, that replaces what the Fed was trying to do in terms of raising interest rates. So I think it makes sense for them to say maybe we're close to the end. We obviously have to watch, very carefully, the economic data as it comes in, but also just some of the very high-frequency data in terms of what we're seeing in terms of deposits and loan growth, especially commercial and industrial lending, commercial real estate lending, where some of these smaller banks are really important to those sectors.

So yeah, I mean, wait and see mode while we try to sort through, do we see calm now? Do things go back to normal? Or is there another shoe to drop? And unfortunately, I don't think anyone has the answer to that.

Greg Bonnell: Yeah, it'd be great if we did have the answers in advance. It would make all of this a lot easier. In the wake of the Fed, you get the Bank of England. You get the Swiss National Bank also raising rates. But here at home in Canada, we are on pause. And we got the Bank of Canada minutes around that thinking. Was there-- now, we're not used to getting minutes from our central bank. I think this is only the second go around. Are we gleaning any information from there, though, in terms of what might they be thinking of going forward?

James Marple: Well sure, I mean, it was funny. They released the minutes at 1:30. And the Fed still was--

Greg Bonnell: Yeah, it was like, look at them front-running the Fed, trying to take all the glory.

James Marple: Yeah, I mean, we-- I didn't even realize it came out until-- because we were so focused on the Fed. But yeah, I mean, a little bit more, nothing too surprising. We got some of their thinking with respect to inflation and what had to happen for inflation to come down toward their target, reflecting some of the strength we've seen in-- continued strength in the labor market. But they had a few statements.

I mean, around inflation, I think it was interesting that they have commented that they see signs that expectations for inflation have risen above a level that they think is consistent with their hitting their 2% target. And they need to see some of that come in. Similarly, on the wage front, that wage growth is higher than is consistent with their 2% inflation target. And of course, seeing what we've seen in the labor market, ongoing, very strong job growth and record low unemployment rate, no signs that that's really going away anytime soon.

So yes, they are on pause. But I think there's probably some risk in both directions with respect to policy there. I think as they've recognized in their statement, and we know, the Canadian economy is more interest-rate-sensitive. And our own forecasts do expect to see some underperformance vis-à-vis the US. So it does make some sense that they would remain on pause. And certainly now, with this uncertainty we've seen in financial markets and the contagion we will see to Canada, a wait and see approach, I think, makes a lot of sense.

Greg Bonnell: They've been telling us all along that to bring inflation down, they're going to have to see the impacts of all these aggressive rate hikes. And the biggest impact would be pain in the labor market. I briefly mentioned the fact that the latest read on US jobless numbers still showing a very strong market there. How come we're not getting that weakness in the labor market? I think-- I would think some of the central bankers are scratching their head right now that we're still not seeing it.

James Marple: Well, I think it's a good question. I think, always, we've seen that the labor market lags some of the other indicators of real economic activity. And we certainly have seen signs that real activity has slowed. But definitely, I think the pandemic and some of the disruption that we've seen there has made reading the tea leaves even more difficult and has probably changed some of the lead and lags in economic variables. And it is a little bit of a mystery.

I mean, we've seen economic activity slow and job growth not show any signs of slowing, in fact, accelerate. Some of it has been in some strange sectors that are not all that cyclical. We've seen, especially in Canada, hiring in government sectors and other places where you could maybe say that's a one-off and probably not going to be maintained. But I agree, it is a little bit of a mystery. But I think in all the forecasts reflecting the slowdown we've seen, we would expect that margin compression, seeing demand start to come in, that is going to show up in the labor market in terms of a slowdown in hiring and a move up in the unemployment rate.

One thing I think that's important in Canada that is a big difference versus the US is just the rate at which the population is growing. And so--

Greg Bonnell: It was, like, over a million people for the first time ever last year?

James Marple: That's right.

Greg Bonnell: That was the number I saw.

James Marple: Exactly. So that very strong population, and therefore labor force growth, creates a higher bar for the number of jobs you have to create before you see some upward pressure on the unemployment rate. So in Canada, I think it's quite possible that we see the unemployment rate go up as the economy is slowing, even if you don't see outright job losses or don't see significant job losses just because you're moving against an increasing target for the number of jobs you have to create just to stay still on the unemployment rate.

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