Under Pressure: Fed Hikes in Face of Bank Turmoil

After a wild couple of weeks of gyrating expectations (and lots of will-they-or-won't-they debates) around Federal Reserve policy, the Federal Open Market Committee (FOMC) announced today a 25-basis-point hike in the fed funds rate, to a range of 4.75% to 5%. It was the second consecutive increase of that size, following a series of larger hikes. Heading into the decision, the market was pricing in an 83% chance of 25 basis points, and a 17% chance of a pause. The decision was (somewhat surprisingly) unanimous.

Importantly, the FOMC's statement said that the "U.S. banking system is sound and resilient," but also warned that "recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation," further noting that the "extent of these effects is uncertain." The statement was missing prior language about inflation having eased, instead noting that price pressures remain elevated alongside job gains that are "running at a robust pace." The statement also had no reference to the Russia/Ukraine war, which was mentioned in the prior statement.

In the immediate aftermath of the failure of Silicon Valley Bank (SVB), the Fed and other regulatory bodies announced backstops, including a new emergency lending facility to banks, as well as an increase in the frequency of U.S. dollar swap lines with foreign central banks (the latter of which the Fed announced last Sunday). Since then, concerns about liquidity led to banks having borrowed a record amount (during a single week) from the Fed's backstop facilities and its discount window, exceeding the prior high during the global financial crisis in 2008. For more details on SVB and the policy response to date, check out our "Another One Bites the Dust" report from earlier this week.

In terms of the near future, the FOMC's statement noted that the Fed "anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time." Relative to what I bolded in that statement, it's interesting that the prior statement said that "ongoing increases" in rates would be appropriate. Perhaps the nuance of the semantics around that change suggests the Fed wants to send a message of flexibility with regard to when to pause/stop rate hikes.

The dots plot is shown below, with the key message that the FOMC is now projecting rates will end 2023 at about 5.1%, unchanged from the median estimate from the last round of projections in December of 2022 (and implying one additional hike from here). Notably, there were seven dots above the median, with one as high as 5.9%, while the median 2024 projection rose from 4.1% to 4.3%. The decision today, as well as the message imbedded in the forecasts, suggests the Fed views still-high inflation as a more significant threat than the current turmoil in the banking system.

The risk, of course, is that the economic growth threat is being underestimated, and the need to continue to combat (the lagging indicator that is) inflation is being overestimated. At the same time the Fed has opted to remain on its tightening path, it's highly likely that many banks—particularly small/regional banks—further tighten lending standards, contributing to elevated recession risk.

Below is the FOMC's summary of economic projections (SEP) with median forecasts and comparisons to the December 2022 projections. We would not put a lot of analysis attention on the forecasts for 2024 or 2025. For this year, forecasts for gross domestic product (GDP) edged lower, but so did the forecast for the unemployment rate, while inflation projections moved up.

As is typically the case, the summary of highlights from Fed Chair Jerome Powell's press conference will include the first 45 minutes or so, in the interest of getting the report into the publishing queue.

• Right up front, Powell noted that "serious problems at a small number of banks" have emerged.
• He also used "sound and resilient" to characterize the broader financial system.
• The "why" behind the Fed's liquidity support announcements is because those problems "if left unaddressed can undermine confidence in healthy banks."
• Powell said the programs are "effectively meeting" liquidity needs to date, but that they are monitoring the situation; while also noting that inflation remains too high and the labor market too tight. 
• Wage growth has eased some, but overall labor demand still exceeds supply.
• Regarding inflation, "without price stability, the economy does not work for anyone" and that inflation imposes "significant hardship."
• In response to first reporter question about confidence if the banking crisis has been contained, Powell did mention an "internal review" being undertaken and that a pause in hike was considered at this week's meeting.
• The internal review is going to be "thorough and transparent" and that "it's clear that we really do need to strengthen supervision and regulation."
• Powell plans to "support the recommendations" of Michael Barr, the vice chair for supervision, who is leading the review of what happened with regulation of SVB, while also "welcoming outside probes of Fed oversight on SVB" and "independent investigations" on what happened with SVB.
• He emphasized that the banking system problems could amount to the equivalent of a rate hike (or more), but that it's too soon to make that judgement.
• In judging the need for additional tightening, the Fed will continue to analyze "incoming data" and "actual effects" from credit tightening.
• In response to a question about today's hike further exacerbating the banking system's woes, Powell replied that the Fed is focused on "macroeconomic outcomes."
• The statement's new language is meant to convey uncertainty over the banking problems on the economy; and that the effects could be modest, or there could be a more significant economic slowdown (in the latter case, the need for additional rate hikes would lessen).
• When asked if he would consider "alternatives" to rate hikes in firming policy, he replied that current "monetary policy tools" work.
• The impact of the turmoil among banks on credit tightening is likely to be "quite real," but it's premature to understand the full effects.
• With regard to SVB, Powell came right out and said the bank's "management failed badly."
• If the economy proceeds as policymakers expect, there "won't be a case" for rate cuts near-term.
• With regard to sufficiency of the Fed's reserves, Powell doesn't envision "running into reserves shortages."
• Powell made it a point to explain the difference between temporary balance sheet expansions that provide liquidity and longer-term programs that may be a part of monetary policy. Read: the recent expansion of the Fed's balance sheet should not be thought of as quantitative easing (QE).
• When asked about whether all bank deposits are now effectively protected, Powell responded that "you've seen that we have the tools to protect depositors" when there is a serious threat to the economy or financial system, and that "regulators will use those tools."
• Nearly simultaneous with those comments, however, was the release of a comment from Treasury Secretary Janet Yellen that they are "not considering a broad increase in deposit insurance."

The Fed has a fairly small opening in the needle it's trying to thread in balancing the threats associated with the banking crisis and the need to combat still-high inflation. Powell made it a point to say there are costs to bringing inflation down to the Fed's 2% target, but the costs associated with allowing inflation to remain high are more severe. We believe the environment is likely transitioning from what has been more of an "asset crunch" to a more traditional "credit crunch," which will slow economic growth (but also help bring down inflation). Although Powell said there remains a "pathway" to a soft landing, we believe what we've been calling a "rolling recession" is more likely to roll into a more formal recession.