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Edward Bell - Senior Director, Market Economics
Published Date: 23 March 2023
The Federal Reserve hiked the Fed Funds rate by 25bps overnight, taking the upper bound to 5%. The hike comes despite the current substantial stress in financial markets, meaning that the Fed is still prioritizing its fight against inflation above other considerations. In the statement accompanying the hike, the Fed said that inflation “remains elevated” while employment indicators are “running at a robust pace.” The Fed also stressed that US banks are “sound and resilient” but that the current stress in markets will mean “tighter credit conditions” although in its statement and in chair Jerome Powell’s press conference later, the precise level of tightening was “uncertain.” The Fed also seemed to downgrade the path of monetary policy at the next meetings, saying “some additional policy firming may be appropriate” rather than its previous language of “ongoing increases” in rates. During his press conference, chair Powell noted that the Fed did consider a pause at this meeting and also that additional rate hikes may still be needed if the inflation picture fails to get closer to target levels, underscoring the level of uncertainty as to the rate trajectory as we near the peak of the hiking cycle.
The March FOMC also came with a new Summary of Economic Projections (SEP). Growth for 2023-24 was revised down marginally while the unemployment rate was also nudged lower. Projections for inflation rose with the Fed estimating PCE inflation at the end of the year at 3.3%, above the Fed’s 2% target and thus still necessitating a restrictive stance on policy. But there was no change to this year’s projection for where rates should end the year with the median projection of 5.125% holding, with 10 FOMC members pitching at that level while one member supported rates going up to as much as 6%, higher than the previous SEP.
Overall, the March FOMC will be put down as an attempt at a dovish hike. Inflation is still an issue and hiking rates is the most effective tool to cool aggregate demand and, eventually, bring prices lower. Similar to the messaging from the European Central Bank last week, Powell noted that the Fed has separate tools to manage liquidity stress in financial markets.
Market reaction to the Fed was clouded somewhat by a simultaneous message from Treasury Secretary Janet Yellen who seemed to rule out a blanket increase in deposit insurance, saying it was “not something we are considering.” Nevertheless, the 2yr UST rallied sharply on the Fed announcement as markets discounted any more tightening, with yields falling 23bps on the day to 3.9367%. The moves this month have been substantial: only as recently as March 7 the 2yr UST was trading with a 5% yield. Market pricing for rates at upcoming meetings has a 25bps tentatively priced in for the May FOMC before cuts start in earnest from the July meeting. Almost 70bps of cuts are priced in from the current effective Fed Funds rate by the end of the year.
Based on the Fed’s own SEP, monetary policy will need to tighten further as PCE inflation will still be above target by the end of 2023. A median Fed Funds projection of 5.125% implies one more 25bps hike, presumably at the May FOMC meeting, though the current volatility in financial markets may prompt a pause. Economic data in the coming weeks will be key for the May meeting though it is probably too early for it to reflect much of the noise in markets. On that basis, we expect that the Fed will be able to move ahead with one more hike before holding rates unchanged over the remainder of the year. But that stable policy view is caveated by an assumption that financial strains are contained. Should markets hit the rocks again, and credit conditions tighten significantly, then the Fed may need to do less on the hiking front to slow growth and curb inflation. The odds of a May hike would then lengthen and we could bring our expectation of rate cuts—currently expected for 2024—forward to the second half of the year.
Source: Bloomberg, Emirates NBD Reserach.
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