On My Mind: Don’t bank on it

The Federal Reserve (Fed) did the sensible thing at its March Federal Open Market Committee (FOMC) policy meeting, and Chairman Jerome Powell delivered a sensible message, in my view. Financial markets gave it a very dovish interpretation, which to me seems off the mark, and which once again diverges sharply from the Fed’s own policy forecasts. There is a substantial degree of cognitive dissonance in the markets’ reaction, as I will argue below.

The Fed raised its policy interest rate by another 25 basis points (bps), to a target range of 4.75%-5.00%. Powell noted that inflation is still too high and the labor market still too hot; he also recognized that the recent turmoil in the banking system seems likely to result in some contraction in credit conditions, which would have the same impact as more rate hikes and therefore would leave less need for additional policy tightening. The Fed consequently weakened its language on future rate moves, from envisioning “ongoing increases” in policy rates to saying that “some additional policy firming” may be needed.

By how much will credit conditions tighten because of the banking sector tensions? The Fed does not know, and neither does anybody else. At this stage, this is the pivotal uncertainty.

Powell however made a strong case that Silicon Valley Bank (SVB) and Signature Bank are very special cases, that their vulnerabilities, mismanaged interest-rate exposure—and in SVB’s case at least—excessive concentration of their deposit base, are not mirrored in any significant number of other financial institutions, and that the US banking system as a whole is in very solid shape. Several recent analyses of the US banking system confirm this assessment. Notwithstanding this, we might still see some credit tightening as banks take a more cautious stance to protect themselves from the risk of deposit outflows, however unlikely.  But with the US economy still growing at a robust pace, a moderate credit tightening seems a lot more likely than a full-fledged credit crunch.

The Fed’s base case, indeed, isn’t that dovish at all—certainly not as dovish as the markets’. In the Fed’s base case, with some tightening of credit conditions, the central bank can limit itself to maybe just one more 25 bps rate hike and then hold rates at the higher level for a while to let inflation come back down to target.

Note that Powell was very explicit in saying that the Fed has a lot more work to do to bring inflation back to 2%; for the last several months, the Fed has made virtually no progress in cooling off the labor market or reducing the inflation rate for non-housing core services, the crucial and sticky measure that accounts for about two-thirds of overall inflation. Should credit conditions not tighten that much, therefore, the Fed might well have to hike more than is currently projected—a possibility that Powell acknowledges.

More important still, Powell stressed that the Fed does not foresee cutting rates in 2023. In fact, the new Fed forecasts have raised the median policy rate for 2024, from 4.1% to 4.3%—if anything, the Fed is signaling it intends to keep rates higher for longer.

The market, in contrast, gives just a 50% chance to even a single more 25 bps rate hike, and is pricing 100 bps in rate cuts below what the Fed’s “dot plot” predicts for year-end.¹

There is a striking dissonance in financial markets’ pricings: The prediction of sharp Fed rate cuts would suggest a deep recession, perhaps precipitated by a credit crunch or a more extensive banking crisis. But risky assets have not sold off commensurately. Any widening in credit spreads has come almost entirely from moves in the underlying risk-free rates. That’s not at all consistent with an economic environment that would force the Fed into rate cuts.

Financial markets seem to have gone back to their old game of predicting a dovish Fed turn by predicated on pure recency bias rather than on an actual worsening in economic conditions. Don’t bank on it. With a tight labor market and inflation running at 5%-6%, that’s just not going to happen, in my view.