Crisis, what crisis? Fed tightens despite banking stress

The Federal Reserve (Fed) raised the key Fed funds rate at its latest meeting on 22 March by 25 basis points (bps) to 5% on its upper bound. The move comes after a tumultuous week in which rate expectations for the meeting moved from a 50 bps hike after Fed chair Jerome Powell’s Congressional testimony, to only a 50/50 chance of a quarter point.

There had been speculation the Fed would pause or even cut rates in response to the failure of Silicon Valley Bank and Signature Bank.

At his press conference, chair Powell highlighted the actions taken by the Fed, the Treasury and Federal Deposit Insurance Corporation (FDIC) to support the banking system and ensure there would be adequate liquidity. However, the decision to continue raising rates did not ignore the situation in the banking sector. The Fed’s statement noted that credit conditions in the economy would be tightened by recent events and forward guidance was softened to say that some “additional firming” of policy may be necessary rather than “ongoing rate increases”.

Fed chair Powell also made it clear that the central bank had scaled back its tightening plans as a result of the failures. He said that the bank crisis was equivalent to one rate hike or possibly more. However, he also noted the disappointing data on inflation which had underpinned his hawkish tone prior to these events - “Inflation is too high and the labour market is tight”. The implication is that in the absence of the events in the banking sector the Fed would have hiked by 50 bps.

The Fed was clearly in a bind over how to react. Had it played up the impact of the banks on the economy and not hiked it might have sparked fears that the situation was worse than the public and markets had feared. Investors would ask, what does the Fed know that we don’t? This could well have led to further deposit withdrawal, more intervention by the authorities and an even greater tightening of credit conditions.

Had it gone ahead with 50 bps, there would be a risk of overdoing it and being blamed for aggravating the situation and triggering a recession. Instead the Fed chose a middle way and Powell emphasised that he saw the banking sector as being healthy and well-capitalised, while noting that the overall impact on the economy is unknown.

The widely-followed dot plot projections of future interest rates only came down by 25 bps. The Federal Open Market Committee (FOMC) and the markets are both looking for one more hike in May 2023. Thereafter, they part company, with the FOMC members keeping rates on hold until 2024 while the market is expecting a 50 bps cut by the end of 2023.

We are with the market on the outlook as we expect a slowdown to gather pace and force the Fed’s hand later in 2023. The banking crisis is a sign that tighter policy is biting and in our view, will tame inflation once the lagged effects have been allowed to come through.