Time for a break, but what comes after is unclear

March 30, 2023 06:00
Photo: Reuters

Jerome Powell was clear on 22 March: the Fed, with the other government agencies, has the tools to address stress in the banking sector, which, as a result, will not undermine its objective of bringing down inflation back to its 2% target. As we had anticipated, the FOMC raised it policy rate by 25bp, but also flagged that the end of the hiking cycle is in sight. The main change to the statement is that the FOMC no longer anticipates the need for ‘ongoing increases’ in order to attain a sufficiently restrictive monetary policy stance, but just that some additional tightening ‘may be appropriate’.

This change of heart since the Chairman’s Testimony earlier in March obviously has to do with the recent bank failures. Credit conditions will most probably tighten further, though the extent, the duration and hence the impact on the economy is still very uncertain. What’s quite clear, however, is that fewer rate hikes will be needed to attain the same objective. The dot plot was little changed compared to December’s (J. Powell mentioned in his Testimony that it would) and indicates that the Fed might hike its policy rate by a final 25bp in May, then would leave it unchanged for the rest of the year.

The new Summary of Economic Projections (SEP) also points to a more challenging environment for growth, with 4q/4q 2023 GDP revised down to 0.4% (from 0.5%), and to 1.2% for 2024 (from 1.6%). Note that this 2023 median projection implies a drop in the level of GDP between now and the end of the year, if GDP falls in line with the Atlanta Fed’s Nowcast measure in the first quarter. The new SEP continues to show a gradual decline in inflation (but according to Powell, a bumpy one), which is projected to get back on target only by the end of 2025. Though projections for unemployment remain broadly unchanged, with a rise to 4.5% by the end of this year (vs. 4.6% previously), the Chair admitted that current banking stress doesn’t help their ‘soft-landing’ case. We clearly see risks to their growth forecasts skewed to the downside, and those to unemployment skewed to the upside.

The current turmoil in the banking sector makes our case for a ‘hard landing’ stronger. Something similar often happens towards the end of a tightening cycle: credit spreads widen, lending standards tighten, which tighten financial conditions and reduce the flow of credit, despite falling risk-free rates. That isn’t a process that the Fed can hope to control with any precision. The question is how quickly the Fed will then resort to cutting interest rates. The risk to financial markets, which still price about 80bps of cuts in the second half of the year, is the Fed will not play ball given sticky and elevated inflation rates.

One thing that surprised us was that FOMC members apparently didn’t discuss QT. They don’t see contradiction in increasing the size of the Fed’s balance sheet through liquidity operations and contracting it via selling bonds, as those serve different purposes. They’re also of the view that reserves in the banking system remain ample. What worries us is their distribution, with smaller regional banks at risk of seeing more deposit outflows. We continue to think that if banking stress builds up further, the Fed is more likely to end QT early and will cut rates prematurely only if instability in the financial system becomes too big to bear.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin