Recent banking failures add another reason to halt interest rate hikes

The debate over the Federal Reserve’s proper course of action for the rest of 2023 was getting a little stagnant in recent months. The argument centered on whether inflation’s persistence was really a sign of an overheated economy that still needed cooling or if it was due to stubbornly large—but dampening —ripples stemming from the huge pandemic and war shocks of previous years. The recent failures of Silicon Valley and Signature banks and chaos in other corners of the banking sector definitely provide a new twist to this debate.

My view on what the Fed should do now in the wake of banking failures is relatively straight-forward:

  • Before the Silicon Valley Bank (SVB) failure, it was already clear that the Fed should pause interest rate hikes at this week’s meeting, based largely on consistent deceleration of nominal wage growth. 
  • The SVB failure and subsequent banking turmoil are far more likely to be demand-destroying events than not. If one thought the Fed already should be reducing the pace of their rate hikes (or even pausing entirely) due to labor market cooling, the fallout from SVB just means this cooling will happen more quickly and hence the case for halting further rate hikes is stronger.
  • It is a genuine problem that interest rate hikes of nearly 5% in a year cause this much distress in the financial sector, indicating a clear failure of bank management and supervision. These failures should be addressed going forward. But they exist today and the fallout of them clearly provides another argument for standing pat on further rate increases.

Even before SVB failure, labor market cooling argued for no further rate hikes

The January consumer price index (CPI) data came in uncomfortably hot after months of good readings. The February CPI data showed a largely sideways movement in inflation. Worse, revisions to 2022 CPI data showed more disinflation in mid-2022 and less in late 2022—providing slightly weaker evidence of consistent disinflation over the course of the year.

However, nominal wage growth—what many have called a “supercore” measure of inflation—has consistently cooled over the course of 2022 and early 2023. Occasionally a single month of data has shown an uptick of wage growth and concerns are raised, but new data then show continued cooling. Figure A below shows annualized rates of wage growth for the latest three months relative to the prior three months. It shows these rates of wage growth for the initial releases of this data from December 2022 to March 2023. While wage growth blipped up in the December 2022 and February 2023 reports, the most recent report shows a clear pattern of consistent nominal wage deceleration.

This deceleration of nominal wage growth should be near-dispositive for arguments about the proper path of interest rates. If the Fed is insistent on 2% price inflation in the long run, this implies that nominal wages can grow at this 2% inflation rate plus the rate of productivity growth, which we will take as 1.5%. This 3.5% wage growth target, however, assumes no increase in the share of total income accruing to labor rather than capital. Given the large decline in labor’s share of income so far in the pandemic-driven business cycle, this means that several years of wage growth as high as 4.5% could be sustained while still seeing price inflation at the Fed’s 2% target. Nominal wage growth (as shown in Figure A) has been running at or below 4.5% for several months now. In short, wage growth is now running where it should be given the state of the business cycle and the Fed’s 2% inflation target—meaning the Fed should stand pat on any further interest rate hikes.

Despite some wobbles, newest vintage of wage data shows clear deceleration: Change in three-month average hourly earnings (annualized rate), last four vintages of data

Observation date Dec. 2022 Jan. 2023 Feb. 2023 Mar. 2023
Apr-2021 3.60% 3.60% 3.70% 3.70%
May-2021 3.30% 3.30% 3.30% 3.30%
Jun-2021 4.70% 4.70% 4.90% 4.90%
Jul-2021 5.70% 5.70% 5.70% 5.70%
Aug-2021 6.00% 6.00% 6.00% 6.00%
Sep-2021 5.70% 5.70% 5.80% 5.80%
Oct-2021 5.50% 5.50% 5.80% 5.80%
Nov-2021 5.80% 5.80% 6.10% 6.10%
Dec-2021 6.10% 6.10% 6.20% 6.20%
Jan-2022 6.10% 6.10% 6.20% 6.20%
Feb-2022 5.60% 5.60% 5.90% 5.90%
Mar-2022 5.20% 5.20% 5.60% 5.60%
Apr-2022 4.50% 4.50% 4.80% 4.80%
May-2022 4.50% 4.50% 4.90% 4.90%
Jun-2022 4.50% 4.50% 4.70% 4.70%
Jul-2022 4.90% 4.90% 5.00% 5.00%
Aug-2022 4.90% 4.90% 4.70% 4.70%
Sep-2022 5.00% 5.00% 4.70% 4.70%
Oct-2022 4.80% 4.60% 4.40% 4.40%
Nov-2022 5.10% 4.50% 4.40% 4.40%
Dec-2022 4.30% 4.60% 4.60%
Jan-2023 4.80% 4.60%
Feb-2023 4.30%
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The data below can be saved or copied directly into Excel.