Leading up to the Federal Reserve’s March 21-22 monetary policy meeting, traders had been expecting the Federal Open Market Committee to ratchet up its key interest rate by 50 basis points because the economy appeared to be surprisingly robust. But then three banks failed and a fourth was teetering. That may have Fed policymakers rethinking their expectation for a rate hike this week and for their rate path ahead.
“Without exception, every tightening cycle has been associated with a financial shock/crisis,” wrote Evercore ISI’s Ed Hyman on Tuesday. “And every financial shock/crisis has ended only after the Fed has at least paused.”
Krishna Guha, vice chairman of Evercore ISI and head of the firm’s Global Policy and Central Bank Strategy Team, expects a quarter-point increase. “However, a hike gets stopped out if Fed officials cannot be sufficiently confident that interventions are locking down stress, which feels like a close call,” he wrote in a March 20 note.
Traders are now pricing in a 25-bp hike, with a probability of 86.4%, according to the CME FedWatch tool. The odds of no rate hike stand at 13.6%, down from a 30.6% probability a week ago, but up from 0% a month earlier.
As a reminder, the Fed has increased its key rate for eight straight meetings, bringing the federal funds rate target range to 4.50%-4.75% from 0.0%-0.25% in the past year, in its drive to push down inflation. Meanwhile, the core PCE price index, the central bank’s preferred inflation gauge, showed 4.7% Y/Y inflation in February, up from 4.6% in January but easing from 5.2% in March 2022.
The situation is fluid as economists assess the shock delivered by the failures of Silicon Valley Bank and Signature Bank, both of which were seized by regulators over a week ago. Days before that, Silvergate Capital (SI) said it would voluntarily wind down operations and liquidate Silvergate Bank.
Joseph Brusuelas, U.S. chief economist at RSM LLP, expects a 25-bp increase on Wednesday, bringing the federal funds rate target range to 4.75%-5.0%, said Tuesday via tweet. He estimates that the financial shock from the bank failures is equal to about 50 bp of policy tightening “as long as the current crisis does not deteriorate further and financial conditions remain tightened.”
“This creates a proxy rate one half of one percent higher than wherever the policy rate rests following the Federal Reserve’s decision on Wednesday,” Brusuelas wrote in a note on Tuesday. With a 25-bp hike, the proxy rate would could be ~5.25%-5.5%, “and that would most likely be the final rate hike in this cycle, all else being equal.”
Morgan Stanley U.S. chief economist Ellen Zentner also expects a quarter-point rate hike, with the caveat that “fast-moving markets mean that views ahead of the Fed will need to remain fluid,” according to a note dated March 17.
With the increased uncertainty, Morgan Stanley economists and strategists expect the FOMC members’ summary of economic projections to stay largely unchanged, while two weeks ago Fed officials’ sentiment indicated moving the peak rate up. “Financial developments over the last week will likely tilt the balance toward inertia,” they wrote.
The Morgan Stanley team expects one more rate hike in May, reaching a peak rate of 5.1%, “but this expectation is highly dependent on near-term developments. Inflation fighting will remain front and center for policymakers as long as the macro environment allows.”
BofA’s rates strategist Mark Cabana, U.S. economist Michael Gapen and FX strategist Alex Cohen expect a 25-bp increase as well, but the “decision and outlook for any tightening depend on financial stability,” they wrote in a March 20 note. “Recent economic momentum and inflation have been overshadowed by banking system risks, sharply repricing the Fed’s path.”
They’re keeping their outlook for a terminal target rate range at 5.25%-5.5% with a mild recession starting in the U.S. from Q3 of 2023. “We now see a greater risk of Fed tightening and balance sheet reduction ending sooner,” Cabana and colleagues said.
With the labor markets carrying more strength into 2023 than previously expected, the BofA team now sees the Fed policymakers increasing their projections for growth, inflation and policy rate path compared with their December estimates. Specifically, they expect the federal funds target rate projection midpoint for the end of 2023 to increase to 5.4% from the previous median estimate of 5.1%. For 2024, they expect the projection midpoint to increase to 4.6% from the previous estimate of 4.1%, and for 2025, 3.4% vs. 3.1%.
In the press conference following the Fed decision, SA contributor James V. Baker expects that Chair Jerome Powell will “emphasize the continuing strength in the employment, the Fed’s intention to make money available to any bank needing funds to meet deposit withdrawals, and the Fed’s continuing commitment to bring inflation down.”
SA contributor Damir Tokic considers the dilemma the FOMC faces this week: to continue its focus on inflation with further tightening, or to refocus on financial stability and pause, or even cut, interest rates.