What happened?

Despite additional uncertainty due to the recent tremors in the banking system, the Federal Reserve’s Open Market Committee raised rates by 0.25% to 4.75%-5.0%. In the dot plot mapping out FOMC members’ expectations for the future rate path, the median dot implied one more hike, while only one dot of the 18 suggested this hike would be the last.

Why did the Fed hike by 0.25%?

Overall, the Fed was confident enough in the stability of the financial system and the general direction of the economic outlook to proceed with the rate hike, despite the banking system turmoil. In the Fed’s view, the banking system remains “sound and resilient, with strong capital and liquidity,” and policymakers have taken powerful steps to ensure that the recent problems do not spread through the entirety of the financial system. They’re confident that they have sufficient tools to do so, to the point that, in addition to the hike, they did not downgrade the near- to medium-term health of the economy in their updated projections.

However, significant uncertainty remains—certainly more than existed at the beginning of March. The Fed’s statement and Chair Powell’s press conference reiterated that. The FOMC perceives that the balance of risks around their growth forecasts is to the downside. They recognize there’s no way to be sure the issues in the banking system won’t sharply contract credit growth in the economy and softened their language regarding future rate hikes, noting “some additional firming may be appropriate” rather than “ongoing increases in the target range” will likely be appropriate.

By raising rates, the Fed made clear that inflation control remains a priority, that inflation remains too high, and that the labor market remains too strong. Prior to the banking turbulence, the past two months’ economic data suggested more robust growth and inflation, which had opened up the possibility of a 0.50% hike. The decision to hike by only 0.25% instead suggests a combination of caution around the banking system’s fragility as well as an expectation that banks’ tightening credit conditions will do some of the work that would otherwise have required further Fed hikes.

The outlook from here

Going forward, bank behavior will be critical to the outlook. Chair Powell indicated in his remarks that deposit flight has stabilized this week. We expect to see the usage of the Fed’s emergency facilities and the discount window stabilize when we get new data on Thursday afternoon. This will be a critical metric for weeks to come. Once the most intense period of this episode passes, the focus will turn to the medium-term impact of credit extension from the banking sector, for which we also get weekly data. The Fed always watches the banks closely, of course, but that scrutiny will be heightened in the coming weeks.

We expect that the Fed is now at the end of this tightening cycle, though the heightened uncertainty limits the degree of our confidence. We doubt the banking issues will cause economic collapse, but we do anticipate further evidence of disinflation in the coming months, with the banking tremors adding to that pressure. That may or may not be enough to deter another hike at the FOMC meeting in May. Our economics team continues to forecast lower growth than does the Fed. We anticipate that if there are further rate hikes, that will bring forward the timing of rate cuts. Yet we still disagree with the market’s expectation of aggressive easing in late 2023 (with almost a full percentage point of rate cuts priced in from June through next January). It would take a significant downturn to put us down that path, which, while possible, is still a risk rather than the base case.