Another Rate Hike

The US Federal Reserve went ahead with its tightening, as it raised rates by another 25 basis points on Wednesday ^[1]. The decision was unanimous, with "very strong across the board" according to Chair Powell ^[2] and in line with market expectations.

Interest rates now stand at 5.00-5.25% and the highest since 2006. This is the result of 500 basis points worth of hikes since the March 2022 lift-off, in order to reign in surging inflation. Chair Powell believes that "policy is tight", but refrained from making a call as to whether it is sufficiently restrictive to achieve the goal of price stability.

Hot Inflation & Strong Labor Market

Although inflation has been coming down over the past months, it remains elevated, with the core readings particularly sticky. Last week's data showed that Headline PCE eased 4.2% y/y in March and core prices – which exclude the volatile food and energy categories – ticked down 4.6%.

Inflation is clearly well above the Fed's 2% target and officials reiterated their commitment to bring it down to that level. Chair Powell noted that this process has a "long way to go", as price pressures "continue to run hot", although the effect of monetary tightening manifests with a lag.

On the other part of the central bank's dual mandate, unemployment is close to five-decade lows, with robust jobs gains and elevated wages. Chair Powell acknowledged a gradual cooling in the labor market, but considers it still "extraordinarily" tight and also spoke of "so much" excess demand.

Financial Stress & Economic Slowdown

The collapse of the Silicon Valley Bank (SVB) back in March had sparked fears over the banking sector. The recent quarterly results showed that big banks were largely unscathed, but financial stress remains, with regional lenders in a precarious position. First Republic disclosed massive deposit outflows and regulators facilitated its sale to JP Morgan Chase. ^[3]

The Fed said that the banking system "is sound and resilient", but expects the credit tightening from these events to weigh on economic activity, hiring, and inflation, even though the extent is uncertain. This tightening along with other factors have sparked fears of an economic slowdown, with the Fed's staff expecting a mild recession this year, as revealed by the minutes of the last policy meeting.

This is not Mr Powell's most likely case though, who expects the economy to grow at a "modest" pace. US GDP expanded by just 1.1% in the first quarter according to preliminary data, with the IMF projecting 1.6% growth this year (from 2.1% in 2022). ^[4]

It is clear the financial stress has forced the fed into a conservative approach, since credit tightening does some of the work for it. Chair Powell alluded to its importance on policy decision, saying that it is a "particular focus" recently and going forward. Last month he had equated the credit tightening with a rate hike or even more. ^[5]

The End is Here (or Close)

This conservative stance was evident on Wednesday's policy statement, which removed the prior forward guidance of "some additional policy firming may be appropriate" ^[6], which Chair Powell dubbed as a "meaningful change".

Even though he did not take further tightening of the table, saying that "we are prepared to do more", the door to a pause is now open. The Fed has now likely reached the terminal rate, which would be in line with its own projections. Chair Powell alluded to that, expressing the feeling that they are "getting close or maybe even there".

No Rate Cuts

Markets definitely view rates as having now peaked, but contrary to the Fed, they anticipate multiple rate cuts ahead. At the time of writing, CME's FedWatch Tool projects the first cut as early as July and assigns the highest probability to rates dropping at 4.50% by the end of the year (from current 5.25%). ^[7]

However markets have been disspoointed before and Fed officials don't share this market view , having dismissed such dovish expectations repeatedly. Mr Powell said that such action would not be appropriate and stressed that "we won't cut rates", because their forecasts show that inflation "is going to come down not so quickly".

Balancing Act

The US central bank found itself once again in tough spot, pulled towards different directions. One the one hand persistent inflation and strong labor market call for a sustained restrictive stance. On the other hand, the recent banking turmoil and prospects of economic downturn call for a less aggressive approach.

The Fed managed to balance these competing factors, sustaining a hawkish bias and the resolve to fight inflation, without taking further policy firming off the table. At the same time, it offered an as-clear-as-it could sign that it has likely reached the terminal rate.

Market Reaction

The decision sparked some volatility with SPX500 initially rising on the "meaningful change" in the statement and the hints that rates could have now peaked. However, the Fed kept more tightening in play and Chair Powell ruled out rate cuts, in a comment that sent the index lower and to a losing Wednesday. The US Dollar meanwhile was also pressured, in a sign of the mixed signal and uncertain outlook, closing the day lower.