Fed Opts for Hike-and-See Approach

Less than two weeks after the second-biggest bank failure in U.S. history, Federal Reserve Chair Jerome Powell made clear that inflation remains policymakers’ top concern.

The Fed chief advised that more Fed tightening may be in store after Wednesday’s interest-rate hike, and that the central bank will raise rates higher than expected if needed. In a press briefing, he also said officials don’t expect to be cutting rates this year—even as the bond market showed traders doubling down on that outcome.

Officials are making a calculated risk that, while the recent banking turmoil will likely slow the economy, it won’t mushroom into a broader financial meltdown. While their predecessors got a similar calculation wrong in 2007, today’s regulators are counting on higher capital and liquidity standards, and a more muscular response, to ring-fence problems today.

“They think they have the tools in place to contain the turmoil in the banking system,” Wells Fargo Chief Economist Jay Bryson said. “There certainly is a risk that this could be a bad decision.”

Powell, during the press conference Wednesday, repeatedly noted uncertainty about the spillover effects from the banking-sector problems on lending. He also shared his impression of the speed at which events unfolded, with “a very fast run” on Silicon Valley Bank that left regulators asking themselves, two weekends back, “How did this happen?”

The Fed at that time declared “unusual and exigent” circumstances in launching an emergency cash facility for banks to help limit contagion from SVB’s downfall. Fast-forward to Wednesday, and Powell assured the country that regulators’ actions demonstrated “all depositors’ savings are safe,” as is the banking system more broadly.

One complication emerged, however: Treasury Secretary Janet Yellen, in a Senate hearing at the same time as Powell’s press conference, said that regulators aren’t looking to provide “blanket” deposit insurance. Those comments contributed to a selloff in equities, with the KBW Bank Index sliding after a two-day rally—showcasing continued nervousness about financial risks. U.S. stock futures advanced, and the dollar fell in Asian trade on Thursday.

What Bloomberg Economists Say…

The Fed weighed the pros and cons of a wait-and-see approach against a continuation of hikes, and chose the latter. That signals an unconditional commitment to the price-stability leg of the Fed’s dual mandate. We think they made the right decision.

— Anna Wong, Stuart Paul & Eliza Winger (economists)

Powell’s comments reflected uncertainty over the banking stress. “It is possible this will have very modest effects on the economy and inflation will continue to be strong,” he said—in which case the Fed might raise rates beyond a range of 5% to 5.25%, officials’ current median estimate for the peak.

It is also possible, he said, that a pullback in lending contributes to lower consumption and demand. “That means monetary policy may have less work to do.”

What’s missing from the coin-toss outlook is a third scenario: unemployment starts to rise amid an already-fragile financial system, triggering defaults on loans by newly income-constrained households, amplifying stress inside banks.

“This has been the most aggressive monetary policy tightening cycle for 40 years, and by going harder and faster into restrictive territory, you naturally have less control over the outcome,” said James Knightley, chief international economist at ING. “This heightens the chances of economic and financial stress.”

The Federal Open Market Committee (FOMC) voted unanimously to increase its target for the federal funds rate by a quarter percentage point, to a range of 4.75 percent to 5 percent, the highest since September 2007, when rates were at their peak on the eve of the financial crisis.

“A key takeaway was how uncertain Powell and the FOMC seem to be on the extent, duration, and impact of tightening of bank lending standards,” said Kathy Bostjancic, chief economist at Nationwide Life Insurance Co.

Bostjancic said Wednesday’s rate increase could have been influenced by markets having mostly priced it in. Powell revealed that officials had considered a pause “in the days running up to the meeting.”

It’s the second straight increase of 25 basis points (bps) following a string of aggressive moves starting in March 2022, when rates were near zero.

“What we know is inflation is too high,” said Phil Orlando, chief equity strategist at Federated Hermes. “This Powell Fed, in our view, has quite literally ripped a page from Paul Volcker’s playbook 40 years ago, and they are going to do what they need to do to get inflation back to target.”

The aggressive yearlong campaign is partly the result of the Fed’s own failing to get ahead of inflation when price gains began to accelerate in 2021. By last year, inflation had jumped to 40-year highs.

Inflation reports for the first two months of 2023 were still hot, with the consumer price index rising 6.4 percent and 6 percent in January and February on an annual basis.

Hiring also continued at a blistering pace, with payrolls rising by more than 800,000 in the first two months.

For all that, though, futures markets forecast that the Fed will start cutting rates as soon as this year—which is to say they see something close to a recession.

—With assistance from Steve Matthews.

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