The Fed's Tough Choice
I don’t envy Fed Chair Jerome Powell; he faces an extremely difficult decision.
I don’t envy Fed Chair Jerome Powell; he faces an extremely difficult decision.
This week, he and his colleagues at the Fed will have to decide whether prioritize the fight against inflation or the stability of the country’s financial system. Making the wrong choice could be disastrous for the economy.
The Fed is going to make its decision on Wednesday March 22.
Up until a week and a half ago, this was shaping up to be a fairly easy decision for the Fed.
We had just gotten a string of economic reports that indicated that inflation was staying stubbornly elevated, so everyone expected the Fed to keep hiking interest rates.
As you can see, after the last Fed meeting in early February, expectations for how high the Fed would raise rates steadily increased as we got really strong data on the U.S. jobs market, followed by two hotter-than-expected reports on consumer price inflation.
After looking at all of this data, Fed Chair Jerome Powell came out on March 7 and he told Congress that the Fed needed to push interest rates higher than previously anticipated.
As you would expect, after his comments, expectations for interest rate hikes rose even more. The market was now expecting a 50 basis point increase in rates at the Fed’s March meeting, followed by a few more rate hikes that would take the fed funds rate up to more than 5.5% by the middle of the year.
This is how the market saw things on March 7, less than two weeks ago.
But of course, things have changed dramatically since then. Three banks in the U.S. have collapsed and many others are on extremely shaky ground.
All of a sudden, inflation isn’t the market’s number one priority—financial stability is.
That’s why Fed rate hike expectations have plunged this week. The market now expects the federal funds rate to fall to below 4% by the end of this year, significantly below the 5% to 5.5% rate it was expecting a couple of weeks ago.
This puts Powell and the Fed in a very tight spot. Do they go along with the market, or do they stay the course with aggressive rate hikes?
There are a few things we’re going to see on March 22 that will tell us where the Fed stands.
The first is: does the central bank hike rates at all? If the Fed is worried enough about the recent turmoil we’ve seen with regional banks, then maybe it completely pauses its rate increases.
Or maybe not. Another possibility is that the Fed hikes rates by 25 basis points. If the Fed is still really worried about inflation, then maybe it wants to keep putting upward pressure on interest rates to fight that.
So, that’s the first decision the Fed needs to make: whether to hike rates or not.
The second decision is to come up with projections for key economic variables—like the unemployment rate, GDP growth, the inflation rate, and interest rates.
This is called the Summary of Economic Projections. These projections come out four times a year and they are essentially the Fed’s best guess for how these economic variables will evolve.
People will be particularly interested in learning where the Fed now expects interest rates to be at the end of the year and beyond.
Will the Fed confirm the market’s expectation for interest rate cuts later this year, or will it stick with its own previous projection of ending the year with rates above 5%?
And then the final thing we’ll be watching for are comments from the Fed. This includes the written statement that comes out along with the Fed’s interest rate decision at 2pm Eastern time, and more importantly, what Powell says in his post-decision press conference at 2:30.
How much weight does Powell and the Fed put on the recent crisis at America’s regional banks?
Are they willing to acknowledge that bank lending is probably going to take a hit, leading to slower economic growth and downward pressure on inflation?
Are they willing to acknowledge that they’ve already hiked interest rates by a huge amount in a short period of time and that it might make sense to pause to see how everything shakes out?
Or, will they continue full steam ahead with rates hikes, prioritizing the fight against inflation above all else?
Personally, I think they should tread very carefully here. It makes a lot of sense to take a step back and see what happens with regional banks. Is this a small fire that quickly goes out? Because if it is, the Fed can quickly ramp its rate hikes back up in the future if it needs to.
But if this turns into a larger banking crisis, then the last thing the Fed wants to do is exacerbate that crisis by hiking rates.
Don’t get me wrong, this isn’t a simple decision for the Fed. Inflation has been too high recently, but they’ve already done a lot to combat that.
As we’ve seen, sometimes it takes a while for the full effect of the rate hikes to hit the economy. Everything the Fed has done over the past year is starting to impact the economy now.
There’s no point in overdoing it until we have a clearer picture of the health of the regional banks and whether there’s other parts of the economy that are facing strains after a year of really big, continuous rate hikes.