United States
The FOMC raised the Fed Funds rate by 0.25%, taking its policy rate to a 4.75%-5% range. Market probabilities going into today’s meeting were finely balanced between a hike and a pause.
A dovish hike?
The Fed addressed the ongoing banking sector concerns, by saying “The US banking system is sound and resilient” but “tighter credit conditions” may result.
The Fed also removed a reference to “ongoing increases” in rates being “appropriate”, in favor of a slightly dovish language that “some additional policy firming may be appropriate”. The Fed’s “dot plot” remained largely unchanged, projecting a year-end 2023 Fed Funds Rate of 5.125%.
Elsewhere, the Fed slightly lowered its growth projections for both 2023 and 2024 (from 0.5% and 1.6% to 0.4% and 1.2% respectively).
Chair Powell, in his Q&A, admitted that the committee had considered pausing the rate hikes but eventually reached a consensus to raise rates for the eight consecutive time, given elevated inflation and tight labor market conditions.
Bank lending conditions may tighten, but this trend had already been underway
It is worth highlighting that lending standards had already been tightening for some time now (Figure 1). We expect recent events to strengthen this trend. Chair Powell acknowledged it is possible that “monetary policy may have less work to do” as a result, albeit conceding it is too soon to know.
Figure 1: Bank lending standards had already been tightening, we expect the trend to continue
Source: Federal Reserve, February 2023: https://www.federalreserve.gov/data/sloos/sloos-202301.htm
Banking sector concerns may help the Fed contain inflation
Generally speaking, tighter financial conditions are one of the mechanisms by which the Fed’s restrictive monetary policy is transmitted into the real economy.
But despite aggressive monetary policy, financial conditions have remained fairly loose in the US up until the last two weeks, as evidenced by the Chicago Fed Financial Conditions index (Figure 2). Looking at the components of the index, the primary drivers behind the recent tightening were rising volatility and non-financial leverage.
Figure 2: Financial conditions have tightened up recently
Source: Federal Reserve, Bloomberg, February 2023
The Fed is keen to separate price stability from banking stability
Chair Powell reiterated that the Fed will use “all our tools” to ensure the stability of the banking sector. He also reenforced the FOMC’s strong commitment to returning inflation to its 2% target.
An example of one the Fed’s “tools” would be the “discount window”, that saw its usage spike last week amid the banking crisis. The Fed’s brand-new Bank Term Funding Program provided additional liquidity as well.
Figure 3: The Fed’s liquidity operations are helping stabilize the banking sector
Source: Federal Reserve, Bloomberg, February 2023
The Fed also continues to coordinate its actions with the Federal Deposit Insurance Corporation and the Treasury regarding banking system stability.
We could be closer to the Fed’s terminal rate
The Fed has stepped closer to a peak in rates, if economic conditions remain consistent with where they are today. We expect the Fed will look to hike at least once more time, depending on how the data evolves. Importantly, the Fed’s job is not yet done on inflation, and Chair Powell was clear to state that rate cuts are “not in our base case” for this year. Despite dramatic repricing of market expectations for rate cuts later in the year, we currently believe they remain an unlikely prospect given sticky inflation pressures.
