The US central bank’s benchmark rate has now been lifted to a range of 5.25-5.5 percent, its highest level in 22 years.

Rates were at near-zero last March. Higher interest rates act as a lever on price growth by choking off economic activity. The impact of the Fed’s action in the past year is starting to show with headline inflation moving closer to the Fed’s 2 percent target, after peaking at more than 9 percent in June 2022. Last month, the consumer price index fell to its lowest level in two years, at 3 percent, down from 4 percent in May.

The Fed is trying to engineer a ‘soft landing’ by snuffing out inflation while avoiding a recession. Looking ahead, analysts have already turned their attention to the Fed’s actions later this year. Some economists predicted another rate hike in the fall, while others thought the Fed will tread water until 2024.

Labour markets remain tight

Despite seismic shifts in monetary policy conditions, unemployment – which typically rises with higher interest rates – has remained at multi-decade lows. Since March 2020, the economy has added nearly four million jobs. Unemployment is now at 3.6 percent, below pre-pandemic levels.

Meanwhile, nominal hourly earnings rose more than expected in June, at an annualised rate of 4.4 percent. Though down 1 percent from the same time last year, wage growth has remained well above the Fed’s 2 percent inflation target.

There have been signs the economy is turning a corner, however. Jobs growth slowed more than expected last month. The US economy added 209,000 new non-farm jobs, lower than economists’ consensus forecasts. In addition, growth in April and May was revised lower by a combined 110,000.

“The latest numbers suggest that rate rises have finally started to cool the labour market,” said Ryan Sweet, Oxford Economics’ chief America economist. “According to our calculations, wage growth will have to continue falling to 3.5 percent … to meet the Fed’s inflation target.”

“Fed board officials are still trying to ring out inflation. But monetary policy affects the economy with a lag, and the full effects from tightening haven’t filtered through the economy yet,” he added. “Officials clearly want to avoid causing too much hardship, including for banks … so we think this will be the last hike in the cycle.”

Banking sector wobbles

At its last policy meeting in June, the Fed kept interest rates steady to monitor the effects of recent jitters in the banking sector.

In recent months, financial institutions have started grappling with stress in their commercial real estate portfolios, as the trend towards remote work has undermined demand for office space.

Household debt is another cause for concern. JPMorgan Chase’s credit card write-offs totalled $1.1bn in the second quarter of this year, up $500m from the same period in 2022.

The six largest US banks — JP Morgan, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley — wrote off $5bn linked to defaulted loans last quarter, double from a year ago, according to analyst estimates compiled by Bloomberg. They are reportedly setting aside an extra $7.6bn for other loans which may go bad.

At the same time, big banks, which benefit from depositor inflows during periods of market volatility, have earned bumper profits in interest income – the difference between what they pay depositors and what they earn from loans. JP Morgan, Citigroup and Wells Fargo earned $49bn in net interest income from April to June.

“On average, lending profits have compensated for a fall in other areas of banking activity. But that’s unlikely to last,” said Karsten Junius, chief economist at private bank Safra Sarasin. “Big banks will have to start offering higher rates to meet competition for deposits, so margins will shrink. This has already happened at the regional bank level,” he noted.

Earlier this year, the US’s regional banks avoided a full-blown crisis following the collapse of the Silicon Valley Bank, and subsequent failures of Signature Bank and First Republic. “Smaller banks with exposure to commercial real estate and uninsured deposits remain at risk. Overall, though, the sector remains resilient and cascading bank runs haven’t taken place,” Junius said.

“For now, we see that inflation is high and the labour market is strong. So, we have maintained our expectations of another rate hike later this year,” he said, echoing a view reflected by other financiers. The CME’s FedWatch, which reflects market expectations about future changes to US interest rates, has predicted a 32 percent chance of another hike in November.

Consumption losing steam?

The surprising resilience of US consumer spending has kept the central bank on alert. According to Dean Baker, co-founder of the Center for Economic and Policy Research, “consumption has remained buoyed by a tight labour market.” He added that, “falling inflation has also probably improved most families’ sense of financial well-being.”

For much of this year, Americans have continued to dish out on retail expenditures, helping to offset weaknesses in other areas of the economy, like business investment and housing starts. If that were to change, the probability of tipping into a recession would rise. “The Fed is concerned about knocking consumption off its perch,” Baker told Al Jazeera.

In May, US consumers spent 0.1 percent more compared to the previous month. That was down from 0.6 percent in April. The recent slowdown in spending, especially on durable goods like used cars, has seen consumption growth slow to a 1 percent annualised rate in the second quarter, after rising to a 4.2 percent rate in the January-March period.

“Interest rates have clearly played a role in softening certain aspects of consumption. More importantly, though, higher interest rates have put paid to re-financing,” Baker said. “If you want to customise your house, for instance, and can no longer access funds by refinancing your mortgage, you’d probably try and pay for it using a credit card.”

Household debt set a new record of $17.05 trillion in the first quarter of 2023, up 5.3 percent, from the fourth quarter of 2022. Liabilities rose in most categories, with new highs observed for mortgages, car and student loans. This principally reflects higher borrowing costs, rather than more new loans.

As the global financial crisis demonstrated, a sudden shock can trigger a spiral of defaults, cratering growth. “I don’t think we’re close to a 2008 moment,” said Baker. “But further rate rises would increase strains on the banking sector. That could result in more loan cutbacks, reduced investment and overshot unemployment. The Fed will want to avoid that.”