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In a unanimous decision across members, the Federal Open Market Committee (FOMC) hiked its target interest rate by 25 basis points (bps), to a range of 4.75% to 5.00%, at its March 2023 meeting. Some market participants had expected (and wanted) the US Federal Reserve (Fed) to instead pause its policy-tightening campaign given the current state of the US banking sector, emphasizing a perceived need to prioritize systemic financial stability over the Fed’s ongoing battle to contain inflation.
The recent banking sector stresses — highlighted by some high-profile bank failures and a wave of deposit outflows from others — are likely to lead to tighter lending standards and overall financial conditions going forward, which should eventually help ease persistent US inflationary pressures. While the Fed’s post-meeting statement tried to assure listeners that “the US banking system is sound and resilient,” it also acknowledged the potentially adverse impact that the events of the past couple of weeks could have on economic growth and inflation.
Meanwhile, in Europe, the acquisition of beleaguered Credit Suisse (CS) by UBS, which was arranged by Swiss regulators, proved that the challenges facing many banks are not unique to the US and prompted coordinated actions by global central banks.
In its updated Summary of Economic Projections (SEP), the Fed projected one more rate hike this year, slightly increased its 2023 inflation forecasts, and upped its policy rate estimate for 2024 to 4.3% (from 4.1% in December 2022). The annual US headline and core inflation rates, as measured by the Consumer Price Index (CPI), held steady at 6.0% and 5.5%, respectively, year over year in February 2023.
Most of the leading economic indicators I track now suggest that US house prices (and shelter costs broadly) will decline more meaningfully over the next six to 12 months than previously thought, as the lagged effects of higher Fed policy rates kick in. Continued US labor market strength bolstered the Fed’s case for its latest rate hike: The unemployment rate ended February at just 3.6%, although many of the recently announced layoffs in sectors such as technology have not yet been reflected in US employment figures.
The Fed retained the caps on its monthly reduction of US Treasuries and agency mortgage-backed securities (MBS) at US$60 billion and US$35 billion, respectively. However, the Fed’s balance sheet is still likely to swell this month in the wake of the US bank failures, which led the Fed to launch a new Bank Term Funding Program (BTFP) that provides much-needed loans (and thus liquidity) to depository institutions. Under this program, rather than being forced to sell “high-quality” US Treasuries and agency securities that have lost significant value due to sharply rising rates, banks and other depository institutions can instead pledge these securities (at par value) as collateral for loans.
In addition to the BTFP, discount window lending now available to existing banks, along with FDIC-backed loans to the new “bridge” entity holding Silicon Valley Bank’s assets, have also increased the size of the Fed’s balance sheet in recent weeks. The combined lending programs will thus effectively unwind the impact of the quantitative tightening program that the Fed has been pursuing since last year (albeit by substituting longer-term for shorter-term holdings, which I think will have less influence on risk asset pricing).
As of this writing, I suspect the Fed may have just reached its terminal policy rate and will likely keep rates “on hold” for the foreseeable future in order to assess whether monetary policy remains restrictive enough to keep pushing inflation lower without tipping the US economy into recession.
In my judgment, the one-two punch of tightening financial conditions, delivered via higher Fed policy rates, and a more restrictive lending environment, should be sufficient to slow US inflation and payroll gains in the coming quarters. I think the Fed will still be reluctant to ease monetary policy ahead of confirmation that both inflation and the labor market are cooling materially. That being said, the Fed’s calculus on that front has clearly changed somewhat over the past few weeks.
Bottom line: The Fed’s delicate balancing act between maintaining financial stability on the one hand, and tamping inflation down to its target level on the other hand, has become even trickier now.
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