The US Fed Delivered a Small Hike, Anticipates One More and Done

Bank Turmoil Constrained the Fed

Just a couple of weeks ago, the US Federal Reserve appeared to be on track to reaccelerate the pace of its rate hike cycle and to stop at a higher terminal rate than previously anticipated. This aggressive approach was driven by strong economic indicators, with Chair Powell acknowledging again yesterday that inflation is still "too high" and the labor market remains "very tight". ^[1]

The collapse of the Silicon Valley Bank however changed that, since according to Mr Powell, recent developments in the banking sector will likely result in "some tightening in the credit conditions" that could weigh on inflation. He added that this tightening can be thought as an "equivalent of a rate hike" or even more.

He went on to say that the "tight" policy setting required to bring down to 2% over time, does not all have to come from rate hikes, but rather it can come from"tighter credit conditions", which will do some of the work for the Fed.

Small Hike & Dovish Shift

Given the stress in the banking system following recent events, Chair Powell revealed that a pause was considered "in the run up" to the meeting, although officials refrained from such a move on Wednesday. Instead, officials unanimously decided to deliver another small increase of 25 basis points, bringing rates to 4.75-5.00% and the highest since 2006, in line with baseline expectations.

Moreover, the central bank softened its forward guidance now anticipating that "some additional policy firming may be appropriate", in order to achieve a sufficiently restrictive policy stance^[2]. This was a clear dovish shift from the "ongoing rate increases" reference of the previous policy statement.

One More Hike Ahead

The decision was accompanied by the latest Summary of Economic Projections (SEP), which showed that officials have not changed their views on the appropriate policy path. The median terminal rate was unchanged at 5.1%, implying one more quarter-percentage hike before pausing. ^[3]

The updated dot-plot was probably a bit more hawkish, since the range widened up to 5.9% (from 5.6% previously), while four officials now see rates above 5.5% this year, compared to just to in the December SEP.

Furthermore, the bank raised its 2023 forecasts for both measures of PCE inflation. Core is expected to go as high as 3.6% (from 3.5%) and headline PCE is projected at 3.3% (from 3.3%). At the same time, officials expect a slightly lower unemployment rate of 4.5%, compared to 4.6% of the previous forecast.

If anything, the combination of higher inflation projections and downgraded unemployment forecast, would call for an upgrade in the terminal rate as well. The fact that the terminal rate was unchanged, indicates a dovish bias.

During his press conference, Mr Powell was asked to what extent the updated projections incorporated the additional tightening from recent event, or officials would need to see this filtering into the data before doing so. The Fed Chair replied "some people" did reflect this situation into the Summary of economic projections.

Markets Expect Rate Cuts

Market pricing is in line with the Fed around the timing and level of the terminal rate, as they expect it to peak at 5.25 in May, but don't agree as to what happens next. Markets expect rate cuts within the year and CME's Fed Watch Tool assigns the highest probability to rates standing at 4.25% by the end of December. ^[4]

The Summary of Economic projections however does not account for such an outcome and Chair Powell stressed that participants "don't see rate cuts" in 2023, according to their baseline scenario.

ECB-Fed Divergence

A week ago, the European Central Bank had not blinked since it delivered another half-percentage rate increase, despite the banking turmoil, which spilled-over into Europe. The elevated level of uncertainty prevent the bank from offering clear forward guidance, but Ms Lagarde noted that officials have "a lot more ground to cover", if their baseline projections hold. More to it, she stressed that they are "not waning" from their commitment to fight inflation and their determination "should not be doubted".^[5]

Furthermore, President Lagarde said that there is "no trade-off" between price stability and financial stability, essentially separating the two. What this basically means is that the ECB uses rate hikes to bring inflation down and won't stop because of the banking rout, as there are other tools for addressing any stress to the financial system.

This approach seems to be different from what yesterday's decision and forward guidance by the Fed pointed towards. The ECB was stayed the course and remained hawkish in spite of the financial stress, while the Fed was constrained to a more conservative stance.

Market Reaction

The renewed policy divergence and the dovish elements in the Fed's statement and projections sent EUR/USD higher on Wednesday, with the pair now moving into its sixth straight profitable day.

The impact on Wall Street was more mixed. SPX500 seemed to be initially helped by the conservative Fed, but then dropped and ended Wednesday lower. This fall however seems to have been at least partly due to Mr Yellen's remarks that she has "not considered or discussed anything having to do with blanket insurance or guarantees of deposits". ^[6]