Joseph Heller’s novel “Catch-22” delved into the impossible conditions imposed upon people caught in situations from which there is no escape because of mutually conflicting or dependent conditions. That Catch-22 is an apt description of where the Federal Reserve finds itself as it lifted its policy rate by 25 basis points on Wednesday amid a quickly evolving global banking crisis.
The Fed, seeking a balance between price stability and financial stability, raised its policy rate by 25 basis points.
Federal Reserve Chairman Jerome Powell is trying to navigate a trilemma that demands the central bank re-establish price stability, minimize unemployment and restore financial stability amid a global banking crisis.
With its quarter-point increase, the Fed signaled that it intends to strike that delicate balance by hiking rates and providing forward guidance that implies a far less restrictive stance than the market had priced in before the recent banking crisis.
The key phrase in the Federal Open Market Committee’s statement that communicates that policy challenge is: “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”
The Fed now forecasts a median policy rate of 5.1% this year, implying only one more rate hike this year, as well as a median 2.5% long-run rate. For next year, it forecasts a 4.3% median rate and a 3.1% rate in 2025.
The Fed has now imposed a soft rate-hike bias into its forward guidance, which in our estimation signals that we are at or near the peak policy rate.
Given our modeling of the recent financial shock that implies a de-facto additional 50 basis points of tightening on top of the 25 basis points just added, the Fed is well into restrictive territory.
The probability of the Fed sticking the landing on this without causing a recession, increasing unemployment and preventing further consolidation in the domestic banking sector would appear to be quite low.
As such, a rate hike in June is roughly the same as an extended pause at this point. The evolution of the data and the extent to which financial conditions ease or tighten, as well as the status of the type of deposit guarantee by the federal government, will most likely drive that decision.
The Fed on Wednesday tried to signal to investors, policymakers and firm managers that it can walk and chew gum at the same time. That is, it has the tools to simultaneously achieve price stability and financial stability. The policy statement, forecast and ensuing press conference attempted to do that.
But that will almost certainly result in higher unemployment under conditions now imposed by the liquidity crisis that has impaired community and regional banks.
Pervasive uncertainty
While the Fed has signaled that it intends to continue in its efforts to restore price stability, financial conditions have tightened to the point where our modeling of the crisis suggests that an equivalent of 50 basis points of policy tightening has occurred. That tightening implies a Fed proxy rate of 5.25% to 5.5% above the federal funds target range of 4.75% to 5% that it has now committed to maintain.
The median rate of 5.1% implied by the Fed’s dot-plot forecast of interest rates through the end of the year suggests that the Fed intends to achieve price stability. Yet the Fed is also cognizant of the risks to the outlook caused by financial instability.
As long as the current crisis does not deteriorate and the liquidity provided by the Fed and Treasury proves sufficient, the Fed can continue to emphasize the price stability portion of its mandate.
But another round of instability in the domestic banking ecosystem or a further roiling of systemically important financial institutions would almost certainly require at the very least a pause in the Fed’s rate hike campaign and a focus on its considerable toolbox to obtain financial stability.
Our research suggests that should the current banking crisis intensify and engulf a systemically important financial institution, the deterioration in financial conditions would be equivalent to a 150 basis-point increase in policy tightening and push the proxy federal funds rate well above 6%.
That would create the conditions for a near-term recession and an abrupt shift in policy toward accommodation before the end of the year.
For now, we expect the status quo to hold and are leaning toward one more 25 basis-point rate hike. That would bring the official policy rate to 5% to 5.25% and would be in line with our estimation of the current proxy rate, which is quite restrictive.
Expecting rapid change
Risk posed to the economy by the banking crisis injects a larger degree of uncertainty around the Fed’s Summary of Economic Projections and rate forecast.
In our estimation the Fed’s growth, employment and inflation forecast is not well aligned with the recent shock.
Given the role played by small and medium-sized banks in residential mortgages, commercial real estate and auto lending, that growth will slow and will most likely tip into recession later this year on the back of tighter lending and rate hikes.
One should anticipate on-the-run updates of the forecast by Federal Reserve members until we have the next one in June.
The SEP acknowledged the obvious, which was that the economy is slowing and inflation was higher than the forecast put forward in December.
The Fed now expects a growth rate of 0.4% this year in contrast with 0.5% previously. The unemployment forecast of 4.6% at the end of the year remains unchanged as did its estimate of headline inflation of 2.5%. The forecast of core inflation ticked up to 2.6% from 2.5% previously.
Growth next year is now expected to be in a range between 1% and 1.5%, unemployment between 4.3% and 4.9%, and core inflation between 2.3 and 2.7%.
Threading the needle
Powell at the outset of his press conference wisely emphasized that deposits are safe and that the Fed has an impressive array of tools to restore financial stability.
Liquidity remains ample and the Fed stands ready to act to maintain the functioning of the financial system.
The prepared statement in the press conference, along with the SEP and dot-plot forecast, reflects a crucial compromise to solve the policy challenge that lies ahead.
Powell also went out of his way to identify that the bank crisis has caused a general tightening of financial conditions that may affect how restrictive policy is. He linked that to the changes in the forecast and the policy statement that indicated some additional policy firming may be needed but was no longer guaranteed.
Powell was pressed on the Fed’s regulatory oversight of the banks and accountability issues. He acknowledged a need to improve supervision and regulation but mostly demurred from directly addressing the issue. Oversight will be an ongoing thorn in the side of the central bank.
Powell was asked a question around the risks to the economy posed by commercial real estate and said that it is not on the level of risks around banks and the economy.
While that is accurate, one gets the sense that the Fed policy path this year and next will be shaped in part by the rollover risk embedded inside the commercial real estate community and the fact that the small and medium-size banks made 67% of the outstanding commercial real estate loans.
The takeaway
The path of monetary policy is uncharacteristically uncertain. It appears that we are at or will soon approach the policy peak for this cycle as policy has moved well into restrictive terrain.
The economic forecast is not well aligned with the current risks to the economic outlook caused by the banking crisis and will need to be revised down at the next FOMC meeting on May 2-3.
Until the fiscal authority can resolve whether the implicit guarantee of bank deposits is sufficient or a more explicit guarantee of those deposits is needed to prevent a further run on banks, the Fed is essentially Plan B.
Serving in that role will require an unusual degree of flexibility on the part of the central bank with respect to both its price stability through the policy rate and the tools it can deploy to restore financial stability.
