Can US interest rates outpace inflation?

Several Federal Reserve officials have indicated that the substantial interest rate hikes over the past two years might need more time to effectively reduce inflation, casting doubt on the likelihood of rate cuts happening this year.

A key point raised by Fed policymakers and some economists is that the higher borrowing costs have not significantly impacted American spending as might have been expected. Despite the Fed’s aggressive rate increases, the proportion of income Americans spend on interest payments remains similar to levels from a few years ago, suggesting these higher rates have not substantially curtailed spending or cooled inflation.

Joseph Lupton, a global economist at J.P. Morgan, noted that the current high rates have not sufficiently slowed the economy, suggesting rates might need to remain high or even increase. Fed Chair Jerome Powell, at a recent press conference, deemed another rate hike “unlikely” at the moment but didn’t dismiss the possibility outright, emphasizing the need for more time to ensure inflation is moving towards the Fed’s 2% target.

Dallas Federal Reserve President Lorie Logan recently mentioned that it’s too soon to consider rate cuts and it’s still uncertain whether the current rates are sufficient to dampen inflation. Logan, part of the Fed’s rate-setting committee, however, doesn’t hold a vote on rates this year.

The ongoing high borrowing costs are likely to disappoint many groups, from potential homebuyers looking for lower mortgage rates to Wall Street traders and possibly President Joe Biden, who could benefit from lower rates during his reelection campaign.

The upcoming government inflation report for April is anticipated to show a slight decrease in inflation to 3.4% from 3.5% in March, although there’s concern that progress on reducing inflation may be stalling after a sharp drop last year.

Despite the Fed’s efforts, raising its key rate to the highest in 23 years at 5.3%, Americans have not significantly increased the percentage of their after-tax income used to service debt, with only a small increase from 9.5% to 9.8% since before the rate hikes began.

This minimal increase is partly because many Americans secured very low mortgage rates over the last decade and a half, particularly during times when the Fed’s key rate was near zero to stimulate the economy. Consequently, their financial situations remain largely unaffected by the Fed’s recent policies. Moreover, many people who previously took out low-rate auto loans are also experiencing little impact from current high rates.

While the average new mortgage rate is now around 7.1%, the average rate across all outstanding mortgages is lower at 3.8%, creating a significant gap between new and existing rates. Neel Kashkari, president of the Federal Reserve’s Minneapolis branch, noted that because many Americans refinanced during the pandemic, the full effect of current mortgage rates has not yet hit consumers.

Larger corporations that locked in low rates before the Fed’s hikes are similarly insulated from the effects of higher borrowing costs.

Despite these conditions, there are signs of financial strain among Americans, with increases in delinquencies on credit cards and auto loans, particularly among younger individuals concerned about affording homes due to high mortgage costs.

However, overall debt levels relative to income are lower than they were during the housing bubble 15 years ago, and the economy has benefitted from pandemic-era stimulus checks and rising incomes, which helped many people reduce their debts.

Tom Barkin, president of the Richmond Federal Reserve, commented that the full impact of higher rates is yet to be felt, given that consumers and businesses are currently shielded by previous debt paydowns and refinancing. Gennadiy Goldberg, an economist at TD Securities, believes that the longer borrowing costs remain high, the more Americans will eventually have to adapt, potentially leading to more home purchases and borrowing at higher rates.