Will the Fed keep interest rates ‘higher for longer’?  

Over the past year, the Federal Reserve (the Fed) has encountered difficulties convincing financial markets of its intention to sustain a tight monetary policy until the battle against inflation is well and truly won. Bond markets have, in fact, frequently ignored warnings from the central bank, as investors have repeatedly bought into the narrative that the Fed would pivot and change course.   

To bring annual inflation back down to 2 percent, the Fed has raised the federal funds rate target range by 500-basis points since March 2022. Despite this, unemployment has fallen from 3.6 percent to 3.4 percent over the same period. Moreover, even as short-dated T-bills have largely tracked the federal funds rate, the yields on longer-dated T-notes and T-bonds have declined lately. Furthermore, the stock market has risen considerably from its October 2022 lows.  

These developments have made more difficult the Fed’s primary task of restoring price stability, forcing the central bank to push toward a higher terminal rate.   

To get a sense of the challenges facing the Fed, it is necessary to review the four traditional channels through which monetary policy is presumed to affect the real economy: the cost of capital, asset prices, credit and the exchange-rate. 

Higher rates potentially deter business investment by raising the cost of capital. They also dissuade household spending on durable goods and real estate. Rate hikes can also raise the discount rate and reduce the present value of various assets, thus generating a negative wealth effect. Additionally, higher domestic interest rates may generate a currency appreciation that reduces net exports. Monetary tightening, by reducing the net worth and cash flow of corporations, can raise the cost of (and limit access to) external finance as well.  

In addition, monetary policy can affect macroeconomic conditions by changing risk perceptions and risk attitudes of various economic actors. This is referred to as the risk-taking channel.   

The Fed relies on financial markets and institutions to transmit its actions to the broader economy. The channels named above constitute the monetary transmission mechanism by which central bank actions affect the broader economy. This is how changes in short-term rates feed through to longer-term rates and general credit conditions, which are not directly controlled by monetary authorities.  

To illustrate the complexities associated with the monetary transmission mechanism in the post-pandemic era, consider the behavior of the typically interest-rate sensitive housing market. Though fixed mortgage rates have risen sharply over the last year, the impact on the national housing market has been somewhat muted because many who locked in 30-year mortgages at historically low rates of 3 percent or less in 2020 and 2021 are not planning a move anytime soon.  

Many homeowners are not seeking to put their homes on the market, and the limited inventory of existing homes is keeping average house prices at elevated levels. While the frothiness observed in 2021 and early 2022 has certainly disappeared, and prices in certain regions have experienced declines from record high levels, the market for single-family homes remains tight in the Sun Belt region and elsewhere.  

Philadelphia Fed President Patrick Harker recently noted: “U.S. households have entered the tightening cycle with very healthy balance sheets. Existing homeowners are also benefiting from low mortgage rates and elevated home equity. This gives a ‘cushion’ for homeowners, making it unlikely that a correction in house prices would trigger widespread liquidity constraints and consumer spending reductions.”  

Likewise, many corporations took advantage of historically low rates in 2020 and 2021 and, consequently, their interest-rate burden is still low and may not rise substantially until next year. Furthermore, the ongoing construction boom is blunting the impact of higher rates.  

The stock market recovery, albeit a top-heavy and narrow rally, has constrained the negative wealth-effect channel. The exchange-rate channel is not particularly relevant for the U.S., as dollar-invoicing of imports and limited dependence on exports largely shields the economy from short-run effects associated with a strong dollar.   

Given the muted transmission of Fed rate hikes via the interest rate, the asset-price, and the exchange-rate channels so far, a lot is riding on the credit and risk-taking channels. The ongoing banking sector turmoil is shrinking credit availability and raising lending standards.     

So, the Fed is caught in a bind. Interest rates will have to be kept higher for longer, since its attempts to curtail aggregate demand have frequently been thwarted by uncooperative financial markets. Yet further rate hikes raise the risk of greater financial instability. But easing up too quickly will entrench high inflation and threaten price stability.   

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.