May FOMC meeting: Powell keeps the market on its toes
Amidst the spike in banking stress and rising concerns around the approaching debt limit, the Federal Reserve (Fed) raised policy rates by 25 basis points today, taking the benchmark rate up to 5.00%-5.25%. After having raised policy rates ten times, by a total of 500 basis points, in just 14 months, the Fed is getting close to wrapping up this tightening cycle—but may not be finished just yet. With inflation still elevated and the labor market still “extraordinarily tight,” Fed chair Jerome Powell has kept the door slightly ajar for another hike.
Today’s Fed statement made an adjustment to the language from their previous March policy statement, removing the words: “the committee anticipates that some additional policy firming may be appropriate.” Although Powell specifically noted that it was a meaningful adjustment, his responses during the press conference emphasized the slow nature of inflation decline and the continued tightness of the labor market, signaling that another rate increase is still a possibility.
A confusing backdrop
Markets had almost fully priced in a 25 bps rate increase, so today’s decision did not come as a surprise. Notably, the recent resurgence in banking sector turmoil, as well as rising concerns around the debt limit and the associated volatility, all but secured the market’s expectation that today’s hike would be the last of the cycle. (Notably, coming into today’s meeting, the market was also pricing in three rate cuts by year-end.)
However, the economic and inflation picture still suggests that the Fed’s work is not yet done. Housing market activity has been showing tentative signs of recovery and consumer spending remains robust. As Powell noted, even though the supply/demand balance has improved slightly in recent months, the labor market remains extremely tight, and wage growth remains inconsistent with the Fed’s 2% inflation target. As such, while inflation has been decelerating, progress towards the target has been too slow.
Additionally, the impact of banking turmoil may not visibly materialize in lending data for several months. Chair Powell provided a spoiler on the Senior Loan Office survey which will be released next Monday, noting that it doesn’t show a sharp tightening in lending activity—which is expected to materialize. As such, the Fed must retain optionality on future policy moves.
Recession outlook: “this time is different”
The minutes from the March Federal Open Market Committee (FOMC) meeting revealed that Fed staff expect a U.S. recession later this year. By contrast, the Fed’s Summary of Economic Projections suggests that a recession will be skirted, and Powell’s own view is that a soft landing is still possible. He pointed to the fact that job openings have declined, and wage increases have slowed without unemployment rising, noting that while a soft landing would go against historic experience, “this time looks different.”
Our own expectation, however, is in line with Fed staff: We expect the U.S. economy to enter recession in 4Q 2023 as small and regional banks pull back on lending, triggering job losses and weighing on consumer spending.
Rate outlook: Everything still to play for
The Fed’s dilemma is becoming more difficult by the day. On one side, the continued resilience of the labor market means that inflation pressures are fading too slowly, and price stability remains out of their grasp. But on the other side, signs of financial instability are growing, and further rate hikes will only increase the risks. Much will depend on how the regional banking space performs in the coming weeks and how lending activity evolves. A credit crunch is likely on its way, but with that still several months away, the Fed’s data dependency may ignore that coming storm.
Financial markets are becoming increasingly nervous about the outlook. Clearly, the Fed is approaching the end of its tightening cycle but, with another rate hike potentially still on the table, the monetary hits may not be over yet.
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