Fed Weighs Further Rate Hikes to Stifle Inflation vs Economic Turmoil

In the United States, the persistently high inflation rate has been a cause of concern for the past three years, leading to sustained increases in the Federal Reserve's prime lending rate. Despite a temporary scare in the banking industry, the Federal Open Market Committee (FOMC) is considering continuing rate hikes, at least until their meeting in May. The latest increase of 25 basis points has raised the target rate to 4.75-5%, but there is a divide among officials on how many more increases are necessary.

Loretta Mester, President of the Federal Reserve Bank of Cleveland, has suggested that a meaningful improvement in inflation would require the fed rate to remain in positive territory for an extended period and would need to be above 5%. Given the recent turmoil in the banking industry and market fragility, the Fed has opted for smaller rate hikes of 25 basis points instead of larger ones. However, projections from fellow Fed members range from as little as one to as many as four more rate hikes. Further rate hikes pose an obvious risk to the US economy but would demonstrate the Fed's commitment to restoring price stability and reducing record-high inflation.

With inflation taking longer than anticipated to decline, the question arises as to whether a recession is the only solution to slowing inflation. The efficacy of the Fed's strategy remains uncertain, and the impact on businesses and the economy as a whole remains to be seen. Let us examine how inflation has responded to rate increases over the past year.

The Federal Reserve’s fight against inflation

The Federal Reserve's first rate hike in over three years was approved in March 2022, raising the prime rate by 25 basis points to a range of 0.25%-0.5%. At that time, inflation stood at approximately 8.5%. Another rate hike of 50 basis points was made in May 2022, bringing the prime rate to a range of 0.75% to 1.00%. Inflation peaked at 9.1% in June 2022, prompting a more aggressive increase of 75 basis points to a range of 1.50% to 1.75%.

Subsequently, there have been six consecutive rate hikes, with the latest being modest increases of 25 basis points as confidence waned, bringing the prime rate to the current range of 4.75% to 5.00%. Inflation has since decreased to roughly 6% as of February 2023, but it remains far from the Fed's target of 2%.

Each rate hike going forward will have a more significant impact on the economy, and there is no consensus on when the Fed may begin to reduce borrowing costs.

Mixed views on possible rate cuts

While Federal Reserve Chair Jerome Powell expects inflation to remain above the 2% target until 2025, and Fed officials are not anticipating rate cuts until 2024, the stock markets foresee cuts of 50 basis points by the end of the year. The Fed will consider multiple factors, including inflation, unemployment, GDP, and other economic indicators, but a recent Bankrate survey shows a 64% probability of a recession in 2023. As the threat of a recession looms and financial conditions tighten, access to funds is becoming increasingly difficult, and small businesses are turning to short-term solutions.

Only time will tell how the market will respond and how the Fed will react, but the possibility of a recession remains a significant concern. The Federal Reserve's actions and decisions will play a crucial role in shaping the economic landscape in the coming months and years.

Steps for businesses to prepare for multiple market scenarios

1. Review and adjust your budget: Analyze your financial situation and make adjustments to your budget as necessary. While budgeting is always a good practice, in advance of potential economic turmoil, it is important to focus on reducing expenses where possible while being mindful of cutting too deeply into areas that may be essential to the business's success in the long term.
2. Invest in technology: Use technology to automate processes, increase efficiency, and reduce costs. This can help your business remain competitive and stay afloat during tough economic times.
3. Focus on customer retention: In a recession, customers may be more price-sensitive and less likely to take risks with new vendors. Focus today on doing what you can to retain existing customers by providing excellent service and offering incentives to keep them loyal.
4. Diversify your customer base: Expand your customer base by targeting new markets or industries. While other businesses may be pulling back in anticipation of economic turmoil, the wisest companies look to these times as opportunities to branch out, oftentimes via acquisition or vertical or horizontal integration.
5. Manage your cash flow: Monitor your cash flow carefully and make sure that you have enough reserves to weather any potential downturn. Consider negotiating better payment terms with vendors or offering discounts for early payment to help improve cash flow. At the same time, remember that cash is a wasting asset that should be deployed where returns on investment are favorable.
6. Stay informed: Keep a close eye on economic indicators, such as unemployment rates, GDP growth, and consumer confidence. This can help you to anticipate changes in the market and make adjustments to your business strategy accordingly.

Overall, businesses should be proactive and take steps to prepare for a potential recession, rather than waiting for it to happen. At UHY, we have specialists ready to help you with each of these steps and more, so that you are prepared for anything that the future holds.