Banking turmoil does little to shift Fed’s focus from the inflation war
In a highly anticipated policy decision, the Federal Open Market Committee (FOMC) voted unanimously to raise the Federal funds rate by 0.25% to a target range of 4.75%-5.00%. In the statement, the Federal Reserve (Fed) acknowledged the potential implications of banking turmoil on the economic outlook but highlighted that at this point, it’s uncertain how big that impact will be. The Fed still feels additional tightening may be needed, but downshifted the phrase “ongoing increases in the target range will be appropriate” to “some additional policy firming may be appropriate,” removing the plurality on the amount of tightening remaining. The Fed also acknowledged recent robust job gains and removed its language on inflation easing. The statement did not include any changes to its balance sheet reduction plan.
The Summary of Economic Projections (SEP) and the median “dot” plot reflected a slightly more dovish picture of slower economic growth, a touch lower unemployment, slightly higher inflation and unchanged policy projections.
Highlights from the SEP:
- The dot plot revealed an unchanged median expectation for the federal funds rate at 5.1% for year-end 2023, suggesting an additional 25 basis point hike to come. Surprisingly, policymakers are projecting less easing next year, suggesting an expectation that policy will have to be tighter for longer to combat inflation.
- While the median expectation was unchanged for 2023, some policymakers are becoming more hawkish. One official now sees rates ending this year between 5.75-6.00%, up from zero in December, and three officials see rates ending between 5.50%-5.75%, compared with two officials in December.
- Expectations for the year-over-year headline and core personal consumption expenditures deflator were nudged higher to 3.3% and 3.6% for 4Q23, respectively.
- Expectations for growth were downgraded, likely reflecting an expected drag from tighter lending conditions in the coming quarters. The unemployment forecast was revised down slightly to 4.5% from 4.6% for 4Q23.
Before the banking crisis, several Fed members had argued that in light of recent inflation and activity data, the fed funds projection for this year would need to be revised higher. Just two weeks ago, Fed Chairman Jerome Powell discussed the idea that the pace of rate hikes might have to increase to 0.50%. The last two weeks of banking sector turmoil convinced the Fed to take a milder approach, but the committee still felt that a hike was appropriate.
At the press conference, Chairman Powell kicked off by addressing banks and affirming that the overall banking system is sound and resilient. Powell revealed that the committee considered pausing but ultimately decided, unanimously, to hike rates. In assessing the need for further hikes, he commented that the Fed will be looking at incoming data and the actual effects from credit tightening, which may, in effect, substitute for rate hikes. Powell remained firm on the committee’s resolve to bring inflation back down to 2% and pointed to the lack of progress in non-housing services inflation. He also pushed back against the notion of rate cuts this year.
Markets initially took the FOMC statement and SEP as dovish, with stocks jumping and the yield curve steepening, but reversed those gains after Powell suggested that the Fed will keep raising rates down the line if they have to.
To be clear, we don’t think the Fed should have hiked today and the central bank has done more than enough tightening to gradually return inflation to target. The banking system turmoil reveals a predictable vulnerability of an economy as rates have whip-lashed from very low levels for the best part of 15 years to now sharply higher levels, and there is likely more pain to come. Financial conditions have tightened meaningfully and lending standards will tighten further, contributing to a further slowdown in economic growth. However, it’s clear the Fed remains steadfast in its inflation focus and if market turmoil settles down in the coming weeks, an additional 0.25% rate hike may still be on the table.