Fed continued to tighten in March despite banking turmoil

Insights for What’s Ahead

1. The Fed hiked interest rates by 25 basis points today, but said it may be close to a terminal rate. It also said that it would allow its balance sheet reduction program to continue.
2. Chair Powell said that the FOMC did discuss pausing rate hikes due to the banking crisis, but that there was strong consensus among FOMC members to go ahead. Despite recent events, he called the US banking system “strong, sound, resilient, and well capitalized.”
3. Both the Summary of Economic Projections (SEP) and Chair Powell were less optimistic about the outlook for the growth and anticipated higher inflation. Chair Powell noted that a soft landing was still achievable. However, he noted that the banking crisis would make achieving a soft landing more challenging.
4. Businesses should expect credit conditions to continue to tighten. Chair Powell noted several times that the banking crisis may have done some of the Fed’s job for it and that financial conditions have tightened more than traditional indicators suggest.

What Were the Fed’s Actions?

The Fed made another 25 basis point rate hike in March and pushed the Fed Funds window to 4.75 – 5.00 percent. Additionally, the Fed elected not to change its program of reducing its holdings of Treasury securities, agency debt, and agency mortgage backed securities (aka Quantitative Tightening). However, the decision to leave the program intact wont prevent the Fed’s balance sheet from continuing to swell due to the introduction of the emergency lending facilities to counter the banking crisis (more here). Chair Powell said that that monetary policy decisions will continue to be made on a meeting-by-meeting basis. However, the SEP indicates that the Fed will hike just once more (25 bps) before holding rates steady for the remainder of 2023.

On the banking crisis, Chair Powell said that an internal investigation is being launched to determine how the Fed missed the failure of Silicon Valley Bank and that he welcomed and expected outside probes. He also noted that the subsequent banking crisis resulted in tighter credit conditions that were actually doing the Fed’s monetary tightening work for it. Finally, Chair Powell noted that the US banking system is “strong, sound, resilient, and well capitalized.”

What Does This Mean for the US Economy?

The Federal Reserve’s Summary of Economic Projections (SEP) anticipates slower real GDP growth over the forecast horizon (Figure 1). The FOMC projects 4q/4q 2023 GDP growth of 0.4 percent and 4q/4q 2024 GDP growth of 1.2 percent. These are downgrades from the growth expectations that were released in December. We forecast -0.6 and 2.2 for these two periods, respectively. The FOMC also raised its expectations for inflation. The FOMC projects 4q/4q 2023 PCE inflation of 3.3 percent and 4q/4q 2024 of 2.5 percent. We forecast 3.1 and 2.0 for these two periods, respectively.

The Fed’s GDP expectations are too optimistic, in our view. Our base case assumption is that the Fed Funds rate will rise to a mid-point of 5.375 percent at the end of 2023 and fall to 3.875 percent in at the end of 2024, vs. the March SEP’s 5.1 percent and 4.3 percent. Our projection for steeper cuts to the Fed Funds rate in 2024 are predicated on the US falling into a recession this year that helps to cool inflation. This, in our view, will give the Fed more room to cut rates next year.