All eyes are on the Fed, now more than ever
All eyes are on the Fed, now more than ever
The Fed faces a tough decision on whether to raise interest rates against the backdrop of banks in turmoil and a country with high inflation. The message tomorrow will loom as large as the decision.
Will the Fed raise the federal funds rate?
The Fed will likely raise rates by 25 basis points to 4.75%, but it might also pause its rate increases tomorrow. To some extent, the outcome depends on whether Jamie Dimon, the CEO of JP Morgan Chase, can steady First Republic Bank and if anything else shows up in the news cycle—good or bad—about the banks. The past few weeks have been up and down to which markets, banks, government officials, and depositors have reacted, greatly complicating the Fed’s job.
Tomorrow the Fed should explain how many basis points of the federal funds rate it estimates are equivalent to the bank failures. That would give us a better sense of how much tightening the Fed is doing with its rate decision tomorrow paired with the banking turmoil. It’s impossible to know with any precision. It is almost surely more than 50 basis points. As a result, even 25 basis points from the Fed would be, taken together, a large move. A pause would still allow notable tightening, of course, how much depends on the effects of the bank failures.
I am in favor of pausing the rate increases tomorrow. I am not using bank failures as a new excuse to pause the rate hikes for the sake of workers. I have also been vocal since last fall that the Fed going so hard and fast—especially after the three 75 basis point hikes in a row—would “break” something in financial markets:
So here we are. I was not the only one who predicted it, and it’s here. The Fed prides itself on being “data-driven.” Silicon Valley Bank, Signature Bank, Silvergate, and First Republic Bank are four important data points that outweigh any data on inflation and the labor market since the last meeting.
What about in May and the coming meetings?
Regardless of the rate decision tomorrow, the Fed will clearly signal that inflation is too high, and more rate increases will likely be necessary. It will affirm that the federal funds will remain high as long as it takes for inflation to come down. It might be overshadowed tomorrow, but the Fed will continue to underscore the importance to people of getting inflation down, while acknowledging the pain for workers:
The Fed won’t bring too much attention—it’s premature—to the fact that if the banking worsens or contagion arises in other financial markets, the Fed may need to step in and cut rates, albeit as a last resort. Lending facilities are the front line, but they may not be enough. It too soon to say, but the Fed has the tools.
Inflation is bad; an unstable financial system is worse.
What will the dot plot say?
I do not expect to see the dot plot—the projections of the federal funds rate by each FOMC participant—or any part of the Summary of Economic Projections on Wednesday. If it shows up, ignore it. I have longstanding concerns about the dot plot; above all, it confuses people more than it clears up.
The last thing we need now is more confusion. Plus, every forecast blew up with Silicon Valley Bank. The FOMC participants have had other more pressing issues than updating their dot plot, which would be near impossible anyway.
Will inflation turn down notably soon?
Yes, by the summer. There are signs already of relief coming.
That’s when the shelter inflation will slow. (It’s less important in PCE (the Fed’s target) than CPI, but it is important.) Wage growth is slowing already, which, according to the Fed, should slow services ex housing inflation. Corporations are going to cool it with margins. Banking turmoil is taking away excuses to keep raising prices so fast, as their input costs inflation is easing.
Also, on the slowing demand, the Fed’s large, rapid interest rate hikes are showing through broadly to credit standards and borrowing costs. And that was before the banking turmoil. I am increasingly worried about a recession in the second half of this year. This summer, we will have a brief shining moment with inflation coming down and before millions start losing jobs.
In closing
The Fed faces a tough decision, arguably in the toughest in many years. All eyes are on them to sift through the banking mayhem of the past few weeks and the stubbornly inflation of the past few years. Also, where are we headed? What the story?
The Fed’s effect on the economy and psychology is real. Godspeed.
In the paid-only post later this week, I will analyze the tightening in the banking sector.
Much appreciated. A pause would be ideal.
I think it is less important whether they raise by 0.25% or pause. It is more important to pay attention to their message, the data and their tone. Rebuilding confidence is their #1 priority tomorrow. Tackling inflation is well underway and many investors (even consumers) are seeing the forward lower trending CPI and PPI. Even labor is bound to come down given the tightening credit conditions among regional banks/local smaller banks because they serve SMBs.