INSIGHTS

On March 28, 2023

Fed Sticks to Their Game Plan

The Federal Open Market Committee (FOMC) raised the Fed Funds rate by 0.25% on March 22, taking its policy rate to a 4.75%–5% range. Market probabilities going into the meeting were finely balanced between a hike and a pause.

A dovish hike?

The Federal Reserve (Fed) addressed the ongoing banking sector concerns by saying, “The U.S. 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).

Fed 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 eighth 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; Insight expects 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 U.S., as evidenced by the Chicago Fed Financial Conditions index — up until the last two weeks that is. The primary drivers behind the recent tightening were rising volatility and non-financial leverage.

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 re-enforced 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* (BTFP) provided additional liquidity as well.

Source: Federal Reserve, March 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.

CRN: 2023-0313-10736 R

*The BTFP was created to support American businesses and households by making additional funding available to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management. Any forecasts or opinions expressed herein are Insight Investment's own as of March 22, 2023 and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.