The US Federal Open Market Committee (FOMC) lifted the funds rate target by 25 bps to 4.75–5 per cent during its March meeting — in line with market expectations.
This represented a slowdown in the pace of tightening, with the Fed previously expected to action a 50 bps hike to curb stubbornly high inflation.
But the collapse of three US-based regional banks due to poor liquidity risk management, and the subsequent deterioration in sentiment across the global banking system, has altered the central bank’s monetary policy stance.
In his post-meeting press conference, Fed chair Jerome Powell acknowledged continued inflationary pressures but said recent banking sector volatility would likely result in tighter credit conditions for households and businesses.
This, he conceded, could undermine the Fed’s long-term macroeconomic objectives and would hence require a moderation of the central bank’s tightening bias.
“It is too soon to determine the extent of these effects, and therefore too soon to tell how monetary policy should respond,” he said.
“As a result, we no longer state that we anticipate that ongoing rate increases will be appropriate to quell inflation.
“Instead, we anticipate that some additional policy firming may be appropriate.”
The Fed’s latest forward projections point to one additional 25 bps hike, with the median expectation among FOMC members pricing in a funds rate of 5.1 per cent by the close of 2023 and no rate cuts.
This is despite hawkish revisions to inflation expectations, with core inflation now tipped to close the year at 3.6 per cent, up from 3.5 per cent.
Continued resilience in the labour market has also been forecast, with the unemployment rate projected to hit 4.5 per cent by year’s end, down from 4.6 per cent.
GDP growth expectations, however, have been revised to the downside, with FOMC participants projecting 0.4 per cent growth in 2023, down from 0.5 per cent.
Reflecting on the Fed’s latest monetary policy call, chief international economist at ING Economics, James Knightley, said the shift in strategy suggests the path to a “soft landing” is increasingly uncertain.
“We are more cautious and fear a tightening of credit conditions raises the chances of a hard landing for the economy,” he said.
ING Economics is now “more nervous” about the economic threat of banking volatility despite assurances from chair Powell that the banking system is “sound and resilient”.
“We are a little more pessimistic, having been on the more dovish end of expectations for interest rate moves in 2023 for quite some time,” Knightley added.
“Our concern was that this has been the most aggressive monetary policy tightening cycle for 40 years and by going harder and faster into restrictive territory, you naturally have less control over the outcome.
“This heightens the chances of economic and financial stress and that is what we have seen over the past couple of weeks.”
According to ING Economics, heightened stress would be underpinned by a sharp decline in credit risk appetite, particularly with chair Powell announcing a review into supervisory and regulatory standards.
“It’s our view that the recent events will make banks more nervous about who they lend to, how much they lend and at what interest rate,” Knightley continued.
“With regulators also likely sensing a need to be more proactive, this could intensify risk aversion and make banks tighten lending standards even more.
“This will hamper credit flows, weigh on the economy, and allows inflation to fall even more quickly.”
Given these concerns, Knightly said the group is a “a little confused” about why the Federal Reserve’s forward projections did not reflect a harder landing for the economy.
ING Economics is anticipating one more hike to the federal funds rate in May, taking it to 5–5.25 per cent.
“But higher borrowing costs and reduced access to credit mean a greater chance of a hard landing for the economy,” Knightley said.
Moreover, despite Powell stating FOMC participants “don’t see rate cuts this year”, Knightley has projected 75 bps of easing in the fourth quarter of 2023.
“Historically it has been just six months between the last hike and the first rate cut,” he observed.
But according to senior Morningstar economist Preston Caldwell, “sharp” rate easing would commence in 2024, in line with the Fed’s forward projections.
“The Fed believes that it can curb financial distress with tools other than cutting the federal-funds rate, clearing the way for monetary policy to remain restrictive in order to continue to fight inflation,” Caldwell said.
He said the economy would not be “immediately cooled off” by financial distress, thus keeping inflation elevated.
“Core consumer price inflation averaged 5.2 per cent annualised in the past three months,” Caldwell noted.
“We do expect inflation to come down most of the way back to normal by the end of 2023.
“But forecasts of rate cuts starting this summer (as the market now expects) look premature.”
The marked shift in the Federal Reserve’s monetary policy posture comes amid fears of further banking collapses in the United States, with the viability of First Republic Bank called into question.
US banking failures have undermined confidence in the global banking system, particularly in Europe, accelerating the decline of Swiss giant Credit Suisse, which has been acquired by local competitor UBS for AU$4.8 billion.
