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The sure-footed Fed of the past year now in doubt about next policy move

Published 03/23/2023, 06:21 AM
Updated 03/23/2023, 11:33 AM
© Reuters. U.S. Federal Reserve Board Chair Jerome Powell holds a news conference after the Fed raised interest rates by a quarter of a percentage point following a two-day meeting of the Federal Open Market Committee (FOMC) on interest rate policy in Washington, U.

By Howard Schneider

WASHINGTON (Reuters) - For the first time in a year the Federal Reserve has left its next policy step in doubt as officials weigh the risks of continued high inflation against a possibly looming U.S. credit crunch that could slow the economy in sharp and potentially unexpected ways.

Walking a narrow line that could leave financial markets both unsettled and guessing about what's next, Fed Chair Jerome Powell said in a news conference that U.S. central bankers will themselves be in the dark until more is known about how banks might change lending in response to the failure of two regional firms caught out by unexpected deposit runs.

The Fed raised its benchmark overnight interest rate by a quarter of a percentage point on Wednesday, the ninth straight policy meeting that ended with a rise in borrowing costs since the current tightening cycle began in March 2022. But for the first time since then, it opened the door to a possible pause in the tightening, while also keeping its options open for a further increase as well.

"It's really ... a question of not knowing at this point," Powell told reporters after the meeting. "How significant will this credit tightening be, and how sustainable? ... This is 12 days ago," that a pair of bank failures reshaped the financial landscape facing the central bank, with potential implications for the real economy and the path of inflation.

Until the March 10 failure of Silicon Valley Bank the higher- and stickier-than-expected path of inflation had warranted steady Fed rate hikes, a singular focus that shaped the policy views of Powell and his colleagues for much of 2022 and several months into 2023.

Graphic-Powell's policy sprint https://www.reuters.com/graphics/USA-FED/FOMC/lbpgnkeyrvq/chart.png

But uncertainty about the health of the banking industry has now touched off a scramble by U.S. regulators, lawmakers and politicians to figure out if a broader financial crisis is developing and how to tighten supervision and regulation in response.

"For the time being they are still gauging the impact of what is going on," said Subadra Rajappa, head of U.S. rates strategy at Societe Generale (OTC:SCGLY). The economy "will feel the pain of tighter landing standards and tighter regulation ... I don't think it is going to be immediate."


"Inflation pressures continue to run high," Powell said on Wednesday, repeating what has been the central bank's tagline since the anti-inflation campaign started more than a year ago.

"We remain highly committed to bringing inflation back down," he said, repeating a promise that since March of 2022 has meant steadily higher projected Fed interest rates as inflation escalated.

This week, however, was the first time since early 2021 that officials raised their outlook for year-end 2023 inflation - to 3.3% from the 3.1% projected in December - without offsetting it with higher projected interest rates. The projection for the year-end 2023 benchmark overnight interest rate remained at 5.1%.

Graphic-Rates to catch up with inflation? https://www.reuters.com/graphics/USA-FED/INFLATION/xmvjoaxxopr/chart.png

The difference is a possible credit crackdown by banks, and "means that monetary policy may have less work to do," Powell said.

"You can think of it as the equivalent of a rate hike ... Perhaps more than that," Powell noted, citing extensive research that made him regard the impact as "potentially quite real."

A decline in the growth rate of U.S. bank lending is a hallmark of recession. If it gets really bad, as it did around the 2007-2009 recession, credit actually contracts and the downturn is all the worse.

Graphic-Overall bank credit https://www.reuters.com/graphics/USA-ECONOMY/BANKS/jnvwyjlokvw/chart.png

Fed officials are watching to see if the U.S. economy hits that middle ground, with the flow of credit slowing and perhaps helping encourage "disinflation," without crashing altogether.

Goldman Sachs (NYSE:GS) on Thursday said the research referred to by Powell pointed to a potential hit to 2023 U.S. gross domestic product growth of three-tenths of a percentage point to half a percentage point as banks slow lending, for example, to rebuild capital buffers pummeled by the drop in the value of some of their assets.

That would be enough to wipe out the median GDP growth projected by Fed officials for this year of 0.4%.

In fact, aspects of the Fed's latest economic projections point not so subtly to recession.

First-quarter economic growth is likely to be strong, with an Atlanta Fed "nowcast" estimating a 3.2% annual growth rate. To get to 0.4% for the year as a whole implies a "sudden stop of activity," argued Tim Duy, chief U.S. economist at SGH Macro Advisors.

Fed officials also see the unemployment rate rising nine-tenths of a percentage point in the remainder of this year. Since the 1950s that much of a rise in unemployment over that short a time has meant a recession.

Graphic-Rising unemployment and recession https://www.reuters.com/graphics/USA-ECONOMY/UNEMPLOYMENT/jnvwyjlgdvw/chart.png


For now, Powell said he thought the banking sector's problems would be contained to California-based SVB and the smaller New York-based Signature Bank (NASDAQ:SBNY), whose failures were deemed a "systemic risk" by U.S. officials and prompted the Fed to rapidly create a new lending facility for banks facing unusual withdrawal demands.

Those facilities as well as other programs at the central bank are meant to address financial stability concerns so monetary policy can address inflation, which is still running at more than double the Fed's 2% target.

Data on the first full week of borrowing from that facility will be released on Thursday, followed by data on Friday showing the systemwide changes in bank deposits.

In his news conference on Wednesday, Powell said deposit flows from banks appeared to have "stabilized over the last week," even as U.S. money market funds attracted their biggest weekly inflows in nearly three years.

© Reuters. U.S. Federal Reserve Board Chair Jerome Powell holds a news conference after the Fed raised interest rates by a quarter of a percentage point following a two-day meeting of the Federal Open Market Committee (FOMC) on interest rate policy in Washington, U.S., March 22, 2023. REUTERS/Leah Millis

But financial conditions are tightening. A Chicago Fed index encompassing interest rates, credit spreads, and other data has turned higher since the bank failures, and Powell said those sorts of measures may underestimate what's happening because they don't fully account for changes in lending conditions.

After raising rates at a record pace over the past year "there is a clear recognition that it may be time to pause," said Rick Rieder, chief investment officer of global fixed income at BlackRock (NYSE:BLK). "The challenges facing the (Federal Open Market Committee) today ... take on a particular aura of complexity."

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