After two weeks of almost non-stop market turmoil and volatility, and just over a year, to the day, from when it first started hiking rates in this cycle, the Federal Reserve (Fed) raised policy rates by 25 basis points (bps), taking the benchmark rate up to 4.75%-5.00% at today’s FOMC meeting. The dot plot showed a peak Fed funds rate of 5.1%, indicating the Fed believes they are nearing the end of their tightening cycle.

The banking sector problems of the past few weeks clearly impacted the Fed’s rate expectations. Fed Chair Jerome Powell emphasized that their statement language had changed from “ongoing increases in the target range will be appropriate” to “some additional policy firming may be appropriate.” Inflation continues to be far too elevated and the labor market still too tight but, increasingly, it seems that tightening credit conditions may do the Fed’s job for them—essentially allowing less Fed action from here.

Remember the past month?

The six weeks since the Fed’s last policy meeting have been extraordinary. Chair Powell’s commentary has flitted from dovish in early February (inflation looked like it was fading), to hawkish in early March (inflation looked like it maybe wasn’t fading), and back to dovish today (the banking crisis potentially triggering tighter credit conditions and weighing on inflation). Market expectations have followed the rollercoaster ride, at one point pricing in a peak Fed funds rate of 5.6% and no rate cuts this year, while today it’s pricing in no further rate hikes and three rate cuts by year-end. In fact, the expected path of the Fed funds rate has done a full round trip back to exactly where it was in early February.

The banking crisis

In the days preceding today’s Federal Open Market Committee (FOMC) meeting, questions had been raised about the Fed’s financial stability vs. price stability predicament, with investors wondering which of the two mandates the Fed would prioritize. Yet, as markets seemingly stabilized in recent days, in the end, the Fed’s decision was perhaps not quite so tough. Their policy actions last weekend (including the introduction of a new Bank Term Funding Program) appear to have contained the financial stability risks, permitting them to focus on price stability.

With credit conditions for households and businesses likely to tighten from here, there will undoubtably be a negative impact on labor demand, consumer spending and, ultimately, inflation. Powell suggested that the banking problems could amount to the equivalent of a rate hike, if not more. Other estimates have suggested the tightening in financial conditions in the past two weeks are equivalent to an additional 150 bps of tightening.

Quantitative easing vs. Quantitative tightening

In today’s statement the Fed noted that it would continue the same pace of balance sheet reduction, even though their recent policy moves to counteract banking sector stress had resulted in an increase in the size of said balance sheet. Powell noted that continued quantitative tightening, at the same time as balance sheet expansion via its liquidity tools, are not at odds and play different roles.

Federal Reserve dot plot
FOMC participants’ projections of the Federal Funds Rate, March 2023

Dot plot with FOMC participants' projections of the Federal Funds Rate March 2023 to 2025

Source: Clearnomics, Federal Reserve, Principal Asset Management. Data as of March 22, 2023.

Updates to the Summary of Economic Projections

The new dot plot and Summary of Economic Projections (SEP) indicates that, from the December SEP, the Fed expects slightly lower unemployment, slightly higher inflation and no change to the rate projection. Overall, while not much has changed for their expectations, the SEP did lean somewhat dovish:

  • The median projection has rates ending this year at 5.1%. This is unchanged from the December forecast and implies that there is just one more rate hike to go.
  • 7 of the 19 participants believe that policy rates would need to rise above 5.1% this year, with one participant seeing rates at 5.825% by year-end. Only one participant sees rates below 5.1%.
  • The other major takeaway was that the dot plot continues to imply no rate cuts this year. Although Powell affirmed that point several times during the press conference, the market doesn’t quite buy it and expects rates to fall to 4.25% by year-end.
  • The median projection then falls to 4.3% in 2024 (4.1% in December) and 3.1% in 2025 (unchanged from December).

The Summary of Economic Projections also showed some meaningful revisions:

  • The core PCE inflation forecast for 2023 was revised slightly higher from 3.5% to 3.6%, and 2024 revised up from 2.5% to 2.6%, with inflation only getting sufficiently close to the 2% target in 2025.
  • The unemployment rate forecast for end-2023 was downgraded slightly from 4.6% to 4.5%, but the 2024 projection was left unchanged at 4.6%. That’s an interesting forecast as, historically, once the unemployment rate starts rising it typically takes a while to stop.
  • GDP forecasts were revised from 0.5% to 0.4% for 2023—still above zero! Yet, Powell noted that downside risks to growth are elevated and, when asked about the impact of the banking failures on the chances of a soft landing, he noted “it’s hard to see how they would have helped.” Our own forecasts see recession in the second half of the year, with the banking sector turmoil inevitably raising the probability of a hard landing.

The one truth we know: Financial conditions will tighten further

A week ago, it seemed the Fed would be trapped by its financial stability mandate on one side and its price stability mandate on the other. In the end, financial market stress appears to be at bay for now, permitting the FOMC to continue its focus on inflation while also acknowledging the financial stability risks.

As Powell noted, attaining price stability will require further tightening of financial conditions. But that tightening doesn’t necessarily need to come from Fed rate hikes, and instead, could come from credit conditions as banks tighten lending standards. As such, marring a renewed surge in inflation, it seems likely that the Fed is nearing the end of its tightening cycle. Unfortunately, the impact on the economy will be the same, whether the tightening comes from the Fed or from credit conditions. While banking sector risks are hopefully at bay, recession risks are still looming.


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