FOMC Preview: Hike Postponed

Summary

• Due to the resumption of market turmoil, I only see a one third probability of a 25bp hike next week.
• Chair Powell is likely to stress that the Fed has all the instruments needed to stabilize the banking system and that financial instability does not constrain monetary policy.
• Because the current crisis is a liquidity rather than a solvency crisis, my long-term view on the terminal FFR is unchanged. However, I expect the Fed to proceed more slowly with rate hikes for the next quarter or so.

Market Implications

• The market could be overpricing a hike next week and largely underpricing the end-2023 FFR.

22 March FOMC: Messaging More Than Action

On balance, I only see a one third probability of a hike at the FOMC meeting next week. As I explained in my February CPI review, the resumption of market turmoil would stop the Fed from hiking out of concern it would tighten financial conditions further.

On Monday, markets normalized. But since then, volatility has returned with market concerns broadening to banks outside the US, including Credit Suisse (Chart 1). It seems unlikely that markets will have stabilized enough by the FOMC on 22 March for the Fed to feel comfortable with a hike.

Fed To Claim Absence of Financial Dominance

I expect Chair Jerome Powell to focus on two key themes: reassuring markets and asserting that monetary policy is unconstrained.

He will likely reassure market participants that the US banking system is safe and sound.  Specifically, Powell is likely to stress that:

• US banks are well capitalized, and SVB was an outlier.
• The Fed will take all necessary steps to ensure ‘depositor savings remain safe’ and confidence in the banking system is intact.
• Powell is likely to provide details on the implementation of its new bank lending facility. The Fed data on its own and commercial bank balance sheets will be published on the 16 and 17 March.

He will likely asset monetary policy remains unconstrained by financial stability. There is a strong incentive for the Fed to claim the current crisis will not have lasting economic consequences since it is partly responsible.

Its responsibility lies in a supervisory lapse (it has launched an inquiry) and rapid increase in rates that, in turn, reflected how far it fell behind the curve. Furthermore, banking supervisors, of which the Fed is prominent member, do not seem to have foreseen the implications of higher yields on banks’ balance sheets.

Powell could stress that:

• Financial stability issues are best addressed through regulation, supervision and targeted liquidity injections rather than interest rate policy (a long held Fed dogma).
• It is too early to determine that the current loss of confidence has impacted materially the medium-term economic and inflation outlook.
• Because the new facility announced by the Fed runs counter to quantitative tightening, Powell is likely to argue that the main policy instrument of the Fed is the federal funds rate (FFR).
• Fed policy will react to changes in the economic and inflation outlook, either positive or negative.

I therefore expect the Summary of Economic Projections to show a limited increase in inflation and a 25bp increase in the terminal FFR. 

In the longer run, the impact of the current market instability on the terminal FFR depends on its impact on the long-term economic and inflation outlook. Because I believe the current crisis is one of confidence and liquidity rather than a systemic crisis, I do not expect lasting changes to the long-term outlook and therefore to the terminal FFR.

However, the Fed could proceed more slowly with rate hikes for a quarter or so. Overall, a 100bp additional rate hikes by end-2023 seem likely.

Market Consequences

Markets are currently pricing a 70% chance of a hike next week against my subjective probability of one third.

Markets are also pricing 100bp in cuts between May and December 2023 FFR. I disagree on two counts:

1. The Fed is unlikely to hike and cut in rapid succession. Given the current uncertainty it would rather pause and assess the consequences of the current crisis before making a move.
2. With inflation running above 7% (median price CPI), the Fed would only cut in a severe recession/systemic banking crisis. In such a scenario, however, it would be more likely to cut 450bp rather than 100bp. The 100bp cut currently priced in could therefore reflect the market giving roughly equal probabilities to a bad scenario where the Fed cut 450bp and a good one where the Fed hikes 100bp. In my view, the probability of the bad scenario is closer to 5% than 50%.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)