The Fed’s job gets tougher and tougher

Another unenviable FOMC meeting

Already facing uncharted territory, the Federal Open Market Committee’s job is only getting tougher. It faces innumerable conundrums: assessing the economic outlook and how recent financial turmoil impacts that, the rate decision, financial stability considerations and communicating decisions. This FOMC meeting from 21-22 March will come with a new dot plot – it may end up heightening confusion.

What to make of the economic outlook?

In the period prior to Silicon Valley Bank developments, the US economy was running hotter than expected. Continued strong labour markets underpinned growth relative to expectation, with forecasts of a US recession often being pushed towards end-2023. Inflation, despite having come down for months, was proving stickier than expected on the downside – getting to 2% was viewed as a more difficult and protracted task. Expectations about the terminal rate had shifted to 5.5% from around 5%, and the Fed Funds rate – after peaking – was viewed as on hold for the remainder of 2023.

Will financial turmoil impact this outlook?

Then along comes the SVB upheaval, major deposit shifts, a collapse in US Treasury yields and plummeting market expectations regarding the Federal Funds rate outlook for the rest of the year. But will the turmoil persist and how might it affect the real economy? This is obviously a huge unknown.

If markets steady in time without much real impact, the FOMC’s outlook for the rest of the year could revert to its pre-SVB thinking on inflation/labour market dynamics. But if volatility persists, including deposit flight from community and regional banks, credit contraction might be in the offing. The FOMC’s timing is smack in the middle of peak volatility and uncertainty and it has little more insight than anybody else.

What to do with the Fed Funds rate?

While a few weeks ago a 50-basis point hike seemed a good bet, now it appears the FOMC faces a coin toss between not hiking and raising by 25bp. Good arguments can be put forward for both.

No rate hike would give the FOMC time to assess the situation, without precluding action when more information becomes available. A pause would further allow authorities to assess the lagged impact of the rapid rate hikes that have already taken place.

In contrast, a 25bp hike would respond to sticky price data. The Federal Reserve must keep its eye on inflation. If the FOMC pauses now, will it be harder to explain resumed rate hikes if needed? Moreover, while financial stability concerns are relevant to the macro outlook, especially if credit contracts, financial stability per se is not part of the Fed’s dual mandate of maximum employment and price stability.

Financial stability considerations and the Fed

Fed officials have long emphasised that monetary policy and financial stability considerations should be separated. Monetary policy should be guided by the dual mandate. Financial stability should be tackled with strong micro and macro prudential policies. Of course, if the financial stability upsets the growth and employment outlook, it relates to the attainment of the dual mandate.

Separation is nice in theory, but it may come up short in practice. Rate cuts/hikes and financial stability are interrelated. The US’s financial stability tools are inadequate. The Financial Stability Oversight Council is weak and overpopulated. The Dodd-Frank ‘designation’ process has been gutted. The US does an inadequate job overseeing non-bank financial intermediation, particularly given the labyrinthian regulatory structure that undermines accountability. The SVB collapse shows again that a ‘small’ bank can potentially trigger systemic contagion and it appears that on-the-ground banking regulators missed obvious red flags.

How to communicate amid the confusion?

Fed Chair Jerome Powell will have the unenviable task of explaining the FOMC’s decisions. Whatever those may be, the case for acting one way or another is arguably balanced and actions will easily be second-guessed. If the Fed pauses, it may be accused of paying too little attention to inflation. If it hikes, given the circumstances, it will be accused of overdoing it, as Senator Elizabeth Warren has already charged.

Powell faces the challenge of how to position the Fed for forthcoming meetings when the outlook faces so many unknowns. He may be pressed on whether the Fed failed in its supervisory role, whether blanket deposit guarantees should be issued and the deposit cap upped and whether quantitative tightening should proceed. While trying to maintain options and keep the Fed’s eyes on inflation fighting, the potential for missteps and market volatility will be even greater than usual, which is the last thing the Fed wants.

Pity the FOMC.

Mark Sobel is US Chair of OMFIF.

Image source: Federal Reserve

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