Federal Reserve Chairman Jerome Powell testifies during the Senate Committee on Banking, Housing and Urban Affairs’ hearing entitled “The Semiannual Monetary Policy Report to the Congress” Tuesday, March 7, 2023 at the Hart Building.
Tom Williams | Cq-roll Call, Inc. | Getty Images
When the Federal Reserve starts raising interest rates, it generally does so until something breaks, according to the collective wisdom of Wall Street.
With the second and third largest bank failures of all time on the books for the past few days and fears more to come, this seems to qualify as a major collapse and reason for the central bank to pull out.
Not so fast.
Even after the failures of Silicon Valley Bank and Signature Bank in recent days that forced regulators to act, markets are still expecting the Fed to continue its anti-inflation efforts. Rising bond yields played a particularly important role in SVB’s demise as the bank faced approximately $16 billion in unrealized losses on held-to-maturity government bonds that had lost principal value due to higher interest rates.
Still, the dramatic events may not even technically qualify as something breaking in Wall Street’s collective consciousness.
“No, it doesn’t,” said Quincy Krosby, chief global strategist at LPL Financial. “Is that enough to qualify as the kind of break that would have the Fed pivot? The market as a whole doesn’t think so.”
While market prices were volatile on Monday, the bias was for the Fed to tighten further. According to an estimate by CME Group, traders indicated an 85% chance of a 0.25 percentage point rate hike when the Federal Open Market Committee meets March 21-22 in Washington, DC. Last week, markets were expecting a 0.50 point move for a brief period after Fed Chair Jerome Powell indicated that the central bank was concerned about the recent hot inflation data.
Thinking about a pivot point
Goldman Sachs said Monday it does not expect the Fed to hike rates at all this month, although few other Wall Street forecasters shared the view. Both Bank of America and Citigroup said they expect the Fed to make the quarter-point move, likely followed by a few more.
Additionally, while Goldman expects the Fed to skip a March hike, it still expects a quarter-point hike in May, June and July.
“We believe that for now, Fed officials will prioritize financial stability and view it as an immediate concern and high inflation as a medium-term concern,” Goldman told clients in a note.
Krosby said the Fed is at least likely to discuss the idea of holding back a rate hike.
Next week’s meeting is a big one in that the FOMC will not only make a rate decision but also update its forecasts for the future, including its outlook for GDP, unemployment and inflation.
“No doubt they’re discussing it. The question is, are they going to worry that it might breed fear?” She said. “You should wire [before the meeting] the market that they will pause or continue fighting inflation. It’s all up for discussion.”
Manage the message
Citigroup economist Andrew Hollenhorst said a pause — a term Fed officials generally don’t like — would now send the wrong message to the market.
The Fed has sought to brush up on its anti-inflation credentials after months of denying rising prices as nothing more than a “temporary” effect from the early days of the Covid pandemic. Powell has repeatedly said that the Fed will stay the course until it makes significant progress in bringing inflation down to its 2% target.
In fact, Citi expects the Fed to continue raising its benchmark interest rate to a target range of 5.5% to 5.75%, compared to the current 4.5% to 4.75% and well above the market rate of 4.75 % until 5 %.
“It is unlikely, in our view, that Fed officials will pause rate hikes at next week’s meeting,” Hollenhorst said in a note to clients. “This would invite markets and the public to assume that the Fed’s resolve to fight inflation only extends to the point of creating bumps in financial markets or the real economy.”
Bank of America said it remains “vigilant” for signs the current banking crisis is spreading, a condition that could change the forecast.
“If the Fed manages to contain recent market volatility and shield the traditional banking sector, it should be able to continue its incremental rate hikes until monetary policy is sufficiently tight,” Michael Gapen, BofA’s chief U.S. economist, told clients . “Our monetary policy outlook is always data dependent; currently it also depends on tensions in financial markets.”
Powell has also stressed the importance of using data to determine the direction he wants to take policy.
The Fed will take its final look at inflation measures this week when the Labor Department releases its February CPI on Tuesday and its PPI counterpart on Wednesday. A New York Fed survey released Monday showed that one-year inflation expectations tumbled over the month.