As Jay Powell fielded questions from journalists on Wednesday following the US Federal Reserve’s decision to plough forward with another interest rate rise, he quipped that it had been “quite an interesting seven weeks”.
The Fed chair was speaking after the bank raised rates by a quarter-point and signalled it might be close to concluding its campaign to stamp out inflation following the most aggressive monetary-tightening campaign in decades.
The end of painful rate rises would normally be a cause for relief, even celebration, but for one inconvenient fact: the reason the Fed thinks it can afford to let up is the worst bout of banking turmoil since the great financial crisis of 2008 — and one that critics of the US central bank argue it should have seen coming.
“They’re afraid that they are getting close to thin ice,” said Diane Swonk, chief economist at KPMG, of the predicament facing the Fed. It must now decide whether to keep slamming the brakes on the economy, or whether a looming credit crunch precipitated by the collapse of Silicon Valley Bank and Signature Bank will do the job for it.
“They want to cool inflation without sending the economy into a deep freeze and that is just a very hard thing to do,” Swonk added.
Powell is right that the US central bank has been on a rollercoaster ride over the past two months or so, as have the investors and traders who hang on its every word.
At the conclusion of the Fed’s February meeting, Powell seemed optimistic the central bank had turned the corner on inflation and that a “soft landing” — where price pressures ease without a painful recession — was in sight.
That quickly gave way to renewed concern that the economy was again gaining momentum. Just two weeks ago, Powell even floated the idea that the Fed could jettison the gradual quarter-point rate rise it had opted for in February and move back to a half-point increase this month. He also warned the Fed would probably have to tighten more than expected to bring inflation back to the central bank’s 2 per cent target.
Now that hawkishness has evaporated, thanks to the implosion of SVB and Signature. Indeed, on Wednesday Powell admitted the Fed had considered taking a pause — that is forgoing a rate rise altogether — this month.
The collapse and government takeover of the two lenders resulted in stress across the banking industry — especially for smaller operators — prompting a group of emergency measures from the Fed and other arms of the US government designed to ward off further contagion.
It is unclear whether policymakers have done enough, with already depressed shares of banks selling off again on Wednesday after Janet Yellen, the Treasury secretary, appeared to rule out blanket guarantees in the near term for deposits over $250,000.
The turmoil could result in exactly the same kind of credit crunch the Fed had hoped to precipitate with tighter monetary policy, albeit one over which the central bank has far less sway, economists warn.
“We’re still in a position where financial conditions need to tighten for inflation to come down,” said Kwok. “But what is hard at this point is that the Fed doesn’t have as much control as it once thought it had. It’s lost some of its ability to determine the path.”
Benson Durham, head of global policy at Piper Sandler and a former senior staffer at the Fed, said: “They always wanted financial conditions to tighten, but to tighten in an orderly way. Having bank runs is the disorderly way.”
In its statement on Wednesday, the Federal Open Market Committee said the banking-related turmoil is “likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation”. The “extent of these effects is uncertain”, it warned.
Powell rammed that point home throughout Wednesday’s press conference. “Such a tightening in financial conditions would work in the same direction as rate tightening,” he said, adding that it could potentially be the equivalent of a “rate hike or perhaps more than that”.
“Of course, it’s not possible to make that assessment today with any precision whatsoever,” he warned.
According to a new set of economic projections, known as the dot plot, most Fed officials still see the federal funds rate peaking at between 5 per cent and 5.25 per cent this year, a quarter-point higher than the level reached after Wednesday’s rate rise. That is unchanged from the December forecast.
In a sign that the FOMC could be closer to ending its rate-rising campaign, the policy statement said “some additional policy firming may be appropriate”. Powell urged reporters to focus on the “some” and “may” in that phrase, although he was adamant that rate cuts are not expected this year.
Ellen Zentner, chief US economist at Morgan Stanley, said the complex economic backdrop meant Powell was right to send a “very vague, very soft” signal. “The Fed is making no promises here,” she added.
Tom Porcelli, chief US economist at RBC Capital Markets, detected a more definitive message: that the “hiking cycle is now over”. “In terms of action, it screams that they recognise the gravity of the moment.”
Given the tumult in the banking sector it is perhaps unsurprising that the Fed slightly downgraded its outlook for the economy, which it expects to grow only 0.4 per cent this year before expanding 1.2 per cent in 2024. Such anaemic growth is a daunting prospect for President Joe Biden, who has said he plans to run for re-election next year.
The unemployment rate is forecast to peak at 4.6 per cent in 2024, a majority of policymakers estimated, as core inflation falls back to 2.6 per cent, still above target.
While Powell maintained that there is still a “pathway” for a soft landing, he acknowledged that it has become narrower in light of recent events.
Durham puts the odds of a recession at about 35 per cent, but in the event of a broader shock to financial conditions, that rises to more than 60 per cent. “The distribution of where things go is just very wide,” he added.
Heaping yet more pressure on the Fed at an already difficult moment is the criticism it has drawn for falling short in its role as a supervisor and regulator of SVB. On Wednesday, the Bank of England said it had warned about mounting risks at SVB well before its collapse.
Rule changes enacted in 2019 under Powell’s watch, which resulted in lighter-touch regulation of smaller banks, are also being called into question.
In an early sign of a bipartisan consensus that the Fed erred in its duty, two senators who could not be further apart on the political aisle introduced legislation that would replace the central bank’s internal investigator with a presidential appointee.
“After the Federal Reserve’s failure to properly identify and prevent the shocking failures of Silicon Valley Bank and Signature Bank, it’s clear we can’t wait any longer for big change at the Fed,” said Rick Scott, a Republican from Florida, who is being supported by Democrat Elizabeth Warren.
“When a bank fails, there are investigations, and of course, we welcome that,” Powell said.