Even with the turmoil in the banking sector and the uncertainty ahead, the Federal Reserve is likely to approve a quarter-point rate hike next week, according to market prices and many Wall Street pundits.
Rate expectations have been on a rapidly swinging pendulum for the past two weeks, ranging from a half-point hike to holding the line, and at one point there was even talk of the Fed possibly cutting rates.
However, a consensus has emerged that Fed Chair Jerome Powell and his central bank colleagues want to signal that while they are braced for the financial sector disruption, it is important to continue the fight to bring down inflation.
This will likely come in the form of a 0.25 percentage point or 25 basis point hike, accompanied by reassurances that there is no predetermined path ahead. The outlook could change depending on market behavior in the coming days, but there are signs of a Fed rate hike.
Federal Reserve Chairman Jerome Powell addresses reporters after the Fed raised its target interest rate by a quarter of a percentage point during a news conference at the Federal Reserve Building in Washington February 1, 2023.
Jonathan Ernest | Reuters
“They have to do something or they lose credibility,” said Doug Roberts, founder and chief investment strategist at Channel Capital Research. “They want to do 25, and 25 sends a message. But what Powell says publicly will really depend on the comments afterwards. … I don’t think he’ll make the 180-degree shift everyone’s talking about. “
Markets are largely in agreement that the Fed will rise.
As of Friday afternoon, there was about a 75% chance of a quarter-point rise, according to data from CME Group, which uses fed fund futures contracts as a guide. The other 25% were in the no-hike camp, expecting policymakers to take a step back from the aggressive tightening campaign that began just over a year ago.
Goldman Sachs is one of the most well-known forecasters not to see interest rates moving, as it expects central bankers in general to “take a more cautious near-term stance to avoid exacerbating market fears of further bank stress.”
A question of stability
Whichever path the Fed takes, it will likely face criticism.
“This could be one of those instances where there’s a difference between what they should be doing and what I think they will be doing. They definitely shouldn’t tighten policy,” said Mark Zandi, chief economist at Moody’s Analytics. “People are really nervous and any little thing could drive them over the edge, so I just don’t get it. Why can’t you just spin around here and focus on financial stability?”
A rate hike would come just over a week after other regulators launched an emergency lending facility to stem a crisis of confidence in the banking industry.
The closures of Silicon Valley Bank and Signature Bank, along with news of instability elsewhere, rattled financial markets and sparked fears more was to come.
Zandi, who has not forecast a rate hike, said it is highly unusual and dangerous to see monetary policy tightening in these conditions.
“You won’t lose your fight against inflation with a pause here. But you could lose the financial system,” he said. “So I just don’t see the logic of tightening politics in the current environment.”
Still, most of Wall Street believes the Fed will continue with its policy direction.
Cuts expected before the end of the year
In fact, Bank of America said last Sunday’s policy measures to halt depositor cash and support banks with liquidity difficulties give the Fed the flexibility to hike rates.
“The recent market turmoil stemming from the plight of several regional banks certainly calls for more caution, but robust actions by policymakers to trigger exceptions for systemic risk are likely to limit the fallout,” said Bank of America economist Michael Gapen , in a customer note. “However, events remain in flux and other stressful events could materialize between now and next Wednesday, prompting the Fed to pause its cycle of rate hikes.”
Indeed, further bank failures over the weekend could once again derail politics.
A key caveat to market expectations is that traders are not assuming that further rate hikes will last. Current pricing signals impending rate cuts, bringing the Fed’s policy rate within a target range of around 4% by the end of the year. A hike on Wednesday would bring the range between 4.75% and 5%.
Citigroup also expects a quarter-point hike, arguing that central banks “will turn their attention back to the inflation battle, which will likely require further hikes in interest rates,” the company said in a statement.
However, the market has not had the benefit of being heard by Fed spokesmen since the financial turmoil began, so it will be more difficult to gauge how officials feel about recent events and how they fit into the policy framework.
The main concern is that the Fed’s actions to curb inflation will eventually push the economy into at least a mild recession. Zandi said a hike next week would increase those odds.
“I think more rational minds will prevail, but it’s possible that they’re so focused on inflation that they’re willing to take their chances with the financial system,” he said. “I thought we could get through this period without a recession, but it took reasonably good policy from the Fed.
“If they raise interest rates, that’s a mistake, and I would call it a egregious mistake,” Zandi added. “Recession risks will become significantly higher at this point.”