One more hike, then what?

Futures markets put the odds of a quarter-point rise at the July FOMC meeting at ninety-eight per cent, so the decision itself is settled. The argument is about what comes next. The Federal Reserve is about to lift its policy rate above 5.25 per cent at the end of the fastest tightening for four decades, and the balance of risks it weighs is tilting toward caution.

From zero to restrictive

Sixteen months ago the target range sat at zero to a quarter of a per cent. Since March 2022 the Fed has raised it at every meeting but one, including four consecutive three-quarter-point moves last year, and it skipped only in June to take stock. Alongside the rate rises it has been shrinking its balance sheet by up to $95bn a month, letting Treasuries and mortgage bonds mature without replacing them. Both levers are pulling the same way, and the second works in the background with less attention than it deserves.

The June projections showed most officials expecting two more increases this year. Wednesday's rise will deliver one of them. Whether the second follows depends on how the committee reads data that will look stronger than its models suggest they should.

Why stopping looks safer

Each extra rise does less to slow inflation and more to raise the odds of a financial accident. Real rates are now well into restrictive territory, so the committee can let time and policy lags do the rest of the work. Pausing to measure the drag from earlier rises is far better than overshooting and setting off a sovereign credit or banking crisis.

The arithmetic of real rates makes the case. With consumer price inflation at 3.0 per cent in June and a policy rate about to sit above 5.25 per cent, the inflation-adjusted cost of short-term money is above 2 per cent. The Fed's own estimate of the neutral nominal rate, the level at which policy neither stimulates nor restrains the economy, is 2.5 per cent. Policy has not been this tight in real terms since before the 2008 crisis.

How a central bank weighs mistakes

A central bank's choice can be framed as minimising expected losses from two kinds of error. Stopping too early risks letting inflation settle above target, which would require more tightening later. Going too far risks a recession or a financial accident, which would force rapid cuts and possibly emergency lending. When policy was loose, the first risk dominated and hiking was cheap insurance. At current levels, the second risk has grown, because each quarter-point adds strain to borrowers who have not yet refinanced at today's rates.

The spring bank failures showed how quickly that strain can turn into a crisis. Silicon Valley Bank did not fail because of bad loans but because rising rates cut the value of its bonds and its depositors took fright. Commercial property owners face a similar reckoning as loans come due at far higher rates. A Fed that keeps raising rates into that exposure is testing the financial system's weakest points one at a time.

What history says about pausing

The Fed has paused well and badly. In 1995 it stopped after doubling rates to 6 per cent, cut modestly a few months later, and the economy grew for the rest of the decade. In December 2018 it raised rates and signalled more, equity markets fell sharply over the following weeks, and within a month the Fed had turned to patience and later cut three times in 2019. The lesson from both episodes is that the last increase is often one too many and that officials rarely know it at the time.

A long pause does not guarantee a soft landing. In 2006 the Fed stopped at 5.25 per cent and held for more than a year while the housing bust gathered pace. The pause did not cause the crisis, but it did not prevent it either, because the damage had already been done by years of loose credit.

The autumn temptation

The hard decisions come at the September and November meetings. By then the Fed will have data showing, very probably, that the labour market remains tight and consumer spending resilient, because lags mean the effect of past rises has not fully arrived. It will also face pressure from long-term yields, which have been rising as the Treasury rebuilds its cash balance after June's debt-ceiling deal suspended the limit until 2025.

Holding steady would not mean declaring victory. It would mean keeping rates at their peak for longer and letting the balance-sheet run-off continue, which is itself a tightening in all but name. Markets would welcome the signal, and borrowers facing refinancing over the next year would gain time.

The distribution of gains and losses also favours a pause. Savers and money-market investors already earn more than inflation, so another increase adds little to their welfare. The costs of further tightening fall on those with floating-rate or maturing debt: small firms with bank credit lines, private-equity-owned companies whose leveraged loans reset every quarter, landlords of offices whose values are falling, and regional banks funding all of them. Those borrowers are also the ones whose distress could turn a slowdown into something worse.

The case for going further

The strongest counterargument is that core inflation remains well above target and wage growth has not slowed enough. Stopping too soon was the error of the 1970s, when the Fed eased as inflation dipped only to watch it return higher. Officials with that history in mind would rather overshoot than undershoot, and a single quarter-point more is unlikely by itself to break anything.

That argument is not frivolous, but it underrates the lags. Rates have been restrictive for less than a year, and the Fed's own research suggests the full effect takes longer than that to appear. July's rise is the easy call. The harder test comes in the autumn, when resilient-looking data will tempt the Fed to keep tightening, and it would be wise to sit on its hands. Holding rates at their July level through the end of the year, rather than adding another increase, gives the best chance of avoiding a banking or credit accident while inflation continues to ease.