Taming inflation remains the Fed’s top priority, but even some central bank officials have expressed greater caution in determining additional hikes after the failure of three US regional banks in two months, including the collapse of First Republic Bank on Monday.

“At moments like this, of financial stress, the right monetary approach calls for prudence and patience — for assessing the potential impact of financial stress on the real economy,” Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said in a forum last month. Goolsbee is the newest voting member of the Fed group that decides interest rates.

Another quarter-point increase would bring the benchmark federal funds rate to its highest level in more than 15 years. It would also be the tenth increase in a row since the Fed began to lift rates in March last year.

At the Fed’s last meeting, officials voted unanimously to raise interest rates by a quarter point, citing data that pointed to persistently high inflation and stronger-than-expected economic activity in the beginning of the year. But more cautious voting members could dissent this time, partly due to fear of a tightening of credit conditions, said Diane Swonk, chief economist at KPMG.

“Inflation is looking sticky, which is what the Fed was trying to hedge against, and that will reinforce their resolve to raise rates in May and make it harder for them to definitely commit to an end to rate hikes,” said Swonk.

Federal Reserve Chairman Jerome Powell’s press conference at 2:30 p.m, and the post-meeting statement, will offer clues on whether additional rate increases are likely in the months ahead, and how credit conditions have shaped up in the seven weeks since the first bank failure.

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A coming credit crunch?

Some evidence has already emerged that banks have toughened their lending standards since March, but the full extent remains to be seen. Swift action from regulators quelled fears of broader financial contagion, and the Fed’s assessment of March’s banking turbulence showed that banks failed because of mismanagement and insufficient enforcement action from regulators.

“The credit crunch is the equivalent of raising interest rates,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. “So if you’re at the Fed and you’re trying to slow the economy, you don’t want the financial system to crash, but it’s OK with you if banks lend a little less, and then you raise interest rates a little less, and that’s why they’ll probably stop after one or two more rate hikes.”

Tighter credit conditions help the Fed curb demand to bring down inflation. Strong demand, coupled with a still-tight labor market, puts pressure on employers to raise wages and hire enough employees to meet demand. Those costs are then passed on to consumers. Fed officials have characterized the labor market as a major source of inflationary pressure.

Data gauging US economic activity has been mixed so far. US gross domestic product rose by an annualized rate of 1.1% in the first quarter from the prior three-month period, a weaker rate than the previous two quarters, but surveys released by S&P Global showed that business activity picked up in April.

“The latest survey adds to signs that business activity has regained growth momentum after contracting over the seven months to January,” Chris Williamson, chief business economist at S&P Global Market Intelligence, said in a release. “However, the upturn in demand has also been accompanied by a rekindling of price pressures.”

And the Employment Cost Index, a comprehensive measure of labor costs, showed that compensation gains picked up in the first quarter, indicating that some underlying forces pushing up consumer prices remain.

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A slowing but still-robust labor market

The broader labor market has started to show clear signs of slowing: Employers added 236,000 jobs in March, the smallest gain in more than two years, and job openings fell to 9.59 million that same month, their lowest level since May 2021, according to the Bureau of Labor Statistics. The ratio of openings to the number of unemployed people seeking work declined to 1.65.

Overall price increases have cooled. The Personal Consumption Expenditures price index, the Fed’s preferred inflation gauge, rose 4.2% in March from a year earlier, down from a 5.1% rise in February. And the Consumer Price Index rose 5% in March from the same month a year ago, down from 6% in February.

Core inflation, which strips out volatile food and energy prices, hasn’t decelerated as fast, largely because of the labor market, which is the main argument against a pause in rate increases. But other measures of inflation are poised to decelerate later in the year.

“Nominal wage growth is a key factor into core services inflation, which is pretty sticky. So when wages are rising, people are going to go out and spend more on services,” said Ryan Sweet, chief US economist at Oxford Economics.

“But the good news is that leading indicators of rental inflation, which is a big component of the CPI, point toward a noticeable deceleration in the second half of the year,” he said.

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