The U.S. Federal Reserve raised its benchmark interest rate by 25 basis points (bps) this week, despite turmoil in the banking sector, as it remains focused on bringing down inflation.
In recent weeks, Fed Chair Jerome Powell opened the door to a potential return to jumbo-sized rate hikes, however after the collapse of Silicon Valley Bank (SVB) and Signature Bank, the Fed chose to proceed with a more modest increase. The 25 bps increase brings the federal funds rate to a range of 4.75% to 5% – a level markets expect could be close to the peak in this cycle.
"Since our previous Federal Open Market Committee meeting, economic indicators have generally come in stronger than expected, demonstrating greater momentum in economic activity and inflation," Powell said. "We believe, however, that events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes."
Inflation remains elevated, with the Consumer Price Index (CPI) rising 6% in February and core services ex-housing inflation (which Powell has cited as the “most important” measure of inflation) up 5% year over year. The U.S. labor market has also shown resilience, with unemployment hovering near multi-decade lows and more than 300,000 new jobs added in February.
The latest Summary of Economic Projections suggests that Fed governors expect only one more rate hike this year. But Powell reiterated the rate cuts were not in the Fed’s “base case.”
“If we need to raise rates higher, we will,” he said. “I think for now, though, we see the likelihood of credit tightening. We know that can have an effect on the macroeconomy, on demand, on the labor market, on inflation.”
Markets ended mixed on the day after the announcement, with the S&P 500 Index down 1.65% and the yields on 2- and 5-year Treasury notes falling around 20 bps. (Bond prices move inversely to yields.)
Here are the latest views from Tim Ng, a fixed income portfolio manager and member of Capital Group’s U.S. rates team.
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Consumer Price Index (CPI): A commonly used measure of inflation that measures the average change over time in the prices paid by consumers for a basket of goods and services. Core goods include commodities less food and energy commodities, and core services include services less energy services. Core CPI includes all items less food and energy.
Credit spread is the difference in yield (the expected return on an investment over a particular period of time) between a government bond and another debt security of the same maturity but different credit quality. Credit spreads typically measure the perceived riskiness of a corporate bond relative to a safer investment, typically the equivalent government bond; the wider the spread, the riskier the corporate bond. A period of widening (increase in the spread) reflects an increase in this perceived credit riskiness. Option-adjusted spread takes into account investors' ability to prematurely redeem a security. The value of fixed income securities may be affected by changing interest rates and changes in credit ratings of the securities.
Duration is a measure of the approximate sensitivity of a bond portfolio's value to interest rate changes.
Yield curve measures the difference between the yields of bonds of different maturities. A yield curve is said to be inverted when shorter term bonds provide higher yields than longer term bonds.
Yield curve steepening occurs with long-term rates rising more than short-term rates, or short-term rates falling more than long-term rates.