The Federal Reserve Dilemma
Just a week ago, Jerome Powell testified to the US Joint Economic Committee. Against a spate of recent data pointing to stickier levels of service inflation fuelled by stronger-than-expected demand and economy, he stood committed to bringing the core inflation back down to 2%. He even explicitly said that rates are likely to go higher than initially projected. And shortly after his testimony within the very same week, the US witnessed the second and the third largest bank failure in history - Silicon Valley Bank (SVB) and Signature Bank. Even though regulators have stepped in to protect and guarantee depositors full access to their funds thereby allaying fears of a broader contagion to a certain extent, these events definitely created a big headache for the Federal Reserve.
What Is The Dilemma?
The current data suggest that the fight against inflation is not quite done yet and the US Federal Reserve acknowledged that. Their primary mandate is to keep US core inflation under 2% to maintain price stability. And they suffered a heavy blow to their credibility in 2021 when they brushed off the rising inflation as "transitory" and failed to act in time then. Now, they are doing what they can to salvage themselves and restore their credibility.
Things would have been more straightforward without the recent bank failures. Yes, we can say these banks failed to manage their risk and maintain the necessary liquidity to avoid a bank run. A rapidly rising rate scenario should not be something they have not considered. But whatever the case, an increasingly hostile interest rate environment is a contributing factor. While the affected banks are not ultra-large Tier 1 banks, more such incidents can indicate a deeper systemic problem and send the markets into a panic. And if interest rates keep going up rapidly, more bank failures may surface.
So if you are Jerome Powell, what will you do?
Brush the bank failures aside, continue with the rate increases, and run the risk of pushing more banks into failure. This carries the risk of widening a crack into a big hole and I might have to eat back on my own words and reverse the policy suddenly. And there goes the credibility again.
Slow or stop the hikes now and look like a joker who flips and flops pretty much bumping up and down like how the S&P 500 is moving. And I also run the risk of inflation flaring back strongly, reversing the prior efforts and causing even more damage down the road. If that happens, I will go down in history as the most "credible" Fed chairman.
I kind of made this look somewhat binary. But the decision process will of course be a lot more complex and long drawn. In any case, he is not in a position most people want to be in right now.
What Is The Market Expecting Now In Terms Of Interest Rates?
A couple of days ago, people are still contemplating an outsized hike of 50 bps to 5.25% at the March FOMC meeting. Now, that 50bps possibility is nowhere to be seen. In fact, almost half the market is thinking the Fed might even pause and stay where it is.
There is also a major upheaval in the projections for rates further down the road. Prior to it, the market was anticipating the Fed Funds rate to keep rising to as high as 5.75% in 2023. But just look at where it is now. Now, the market thinks Fed will hike the rates only to 5% by May, and thereafter they will start to ease off. And at year-end, we will be looking at a Fed Funds rate of 4%.
The yields of the longer-term Treasuries also fell sharply during this period as investors flock to safety and start to price in recession risk. The 10-Yr yield has fallen more than 50 bps in a week from 4.08% to 3.55%.
Watch Out For Volatility Ahead
Now, these are just what is being priced at the moment. Markets have a tendency to overreact when uncertainty still hangs around. So be prepared for volatility, especially in light of upcoming inflation data and the March FOMC. What the Fed does in this coming meeting can potentially deviate from what half the market participants expect. Of course, whether they hike 25 bps or stay flat this round is just one thing. The market will be a lot more interested to know whether the cracks appearing in the financial system will tone them down.
My personal opinion is this. It is unlikely the Fed will commit itself to any clear path. And it makes sense since no one knows what is to come. While I think the recent bank runs will definitely feature in their discussion and they may slow the hikes, however, they are unlikely to back off as excessively as what is being priced in the market now short of indications that inflation or demand is also caving in. The recent resolution following the fallout of SVB and Signature Bank with the guarantee of deposits to affected customers and the set up of a Bank Term Funding Program as a financial backstop seems in part to prepare ahead for more pain if rates were to rise.