The FED doesn’t blink

Given the recent developments in the banking sector, we had suspected that the Fed could have considered a 2023 pivot as lenders’ health can materially impact financial conditions. Chairman Powell, however, dismissed that scenario, noting that the FOMC does not see a rate cut occurring this year. In fact, the Fed’s much ballyhooed DOTS survey revealed that respondents see the fed funds rate finishing 2024 at 4.3% – slightly higher than the 4.1% suggested in its December survey. We interpret this as the Fed being willing to leave rates at their cycle high for longer than what the market is currently pricing in. Such a pause would give the central bank time to assess the impact of previous rate hikes and other tightening initiatives.

We believe the Fed was correct in shifting the conversation back toward its battle with inflation. 

Even before most people had ever heard of Silicon Valley Bank (SVB), the Fed was faced with striking a delicate balance between reducing inflation and inflicting as little harm as possible on the economy. That battle has not gone away.

Breaking something

Bringing this full circle, the stress to regional banks that initially caused a historic rise in rates may, in the end, assist the Fed in tightening financial conditions. Mr. Powell made a point to highlight that households and businesses are likely to face tighter credit conditions. This is in addition to higher rates already negatively impacting the housing market and business investment. 

Narrowing rates’ range of outcomes?

We think recent developments – and the Fed’s decision – leaves much for investors to digest. In one respect, the added headwind of tightening credit conditions means that the near-term ceiling for interest rates may be lower than it was in early March. This could lead to lower volatility in shorter-dated bonds. Still, we see a disconnect between the yield on the 2-year U.S. Treasury of roughly 4.0% and the end- of-2023 DOTS projection of 5.1% for the fed funds rate. This disparity may reflect the Fed’s concern that it’s too soon to declare victory in its battle against inflation.

Recent market and economic developments have no doubt tested the Fed. We appreciate that its focus remains on price stability, as imbedded inflation expectations can lead to long-lasting price distortions across the economy. By recognizing that it has the facilities at its disposal to address financial stability, the Fed can keep another 25 bps rate hike on the table should consumer prices remain uncomfortably hot and the labour market tight.