The Federal Reserve on Wednesday raised interest rates by a quarter of a percentage point, but indicated it was on the verge of pausing further increases in borrowing costs amid recent turmoil in financial markets spurred by the collapse of two U.S. banks.
Markets were well positioned for the rate hike, and stocks rose immediately following the decision. But trading was volatile, and the major North American stock indexes all closed well into the red. Meanwhile, the accompanying commentary from the Fed that suggested the rate hike cycle is nearing an end was generally perceived by markets as being dovish and sparked a big drop in shorter-term bond yields. By late afternoon, the 2-year bond yield in the U.S. - which is particularly sensitive to changes in Federal Reserve policy - was down more than 20 basis points to under 4%. It was above 5% at the start of this week. The Canadian bond of the same duration saw a similar move. And the Canadian five-year government bond, highly influential on fixed mortgage rates, was yielding 2.79%, down about 18 basis points and retesting its lows from mid-January.
Money markets are continuing to price in at least a quarter point interest rate cut at both the U.S. Federal Reserve and the Bank of Canada this summer.
Here’s how market followers are reacting:
Avery Shenfeld, chief economist, CIBC Capital Markets
The Fed decided that it could indeed walk and chew gum at the same time, pressing on with a quarter point rate hike to quell inflation, and obviously relying on other interventions to address concerns over financial system stability. The rate hike was a unanimous vote, but still reflected a view that banking issues are a new drag on growth and lending activity, since the committee was clearly aiming at a 50 basis point move before the news broke about regional banks. The accompanying forecast shows a median forecast that includes a further quarter point hike this year, and in the biggest diversion with market chatter, doesn’t show a cut until 2024, with the median end of year forecast for that year, at 4.3%, actually slightly higher than the December projection. But the Fed is no longer so certain about any of this, given the references to the uncertainties on the spillover from financial system issues, and the fact that the wording on further hikes no longer refers to “ongoing increases” but a more nuanced statement that “some” further tightening “may” be appropriate. Growth forecasts were only slightly lower, with the inflation outlook a hair higher. ...
Market participants can choose hold onto their hopes for rate cuts this year for a while, on the grounds that the Fed’s hiking forecasts have, at the end of a tightening cycle, often showed further increases that didn’t in fact happen. Typically, the Fed starts to show some softening of those further hikes, as they have today, before then flipping into a pause or even some cuts. But at this point, our prior forecast, which was for a quarter point hike today and a follow-up in May, seems in line with the FOMC’s thinking, as well as indications that, at least for Q1, growth and hiring will still have been running too hot for the central bank’s liking. So we’ll stick with our view that May will see a final quarter point hike, and that rate cuts will await 2024, expecting policy makers at the Fed and the Treasury to use other tools to maintain a sufficiently liquid banking system.
David Rosenberg, founder of Rosenberg Research
Reading the statement, you wouldn’t think that we were coming off a major banking crisis (I mean — “The U.S. banking system is sound and resilient.”). So sound and resilient that the central bank spent most of the past week doing its utmost to ward off a crisis. Hiking rates another 25 basis points into an inverted yield curve is certainly not going to do anything to alleviate the strains (strains caused by the Fed’s own aggressive posture this past year in the most acute interest rate shock since 1981).
The really big change was in the forward guidance, shifting the language from the “Committee anticipates that ongoing increases in the target range will be appropriate” to the “Committee anticipates that some additional policy firming may be appropriate”… so going from “will” to “may” is significant and not mentioning rates this time around simply means that the “policy firming” will just come from quantitative tightening.
This is the first time the Fed has raised rates coming out of a crisis since February 1995 when it went 50 basis points right after Orange County declared bankruptcy and the Mexican peso was forced to devalue. That was the last hike of that cycle and the Fed began cutting in July 1995 — even with no recession. But back then, it didn’t overstep by inverting the yield curve so this situation is far different and a soft-landing is simply out of the question. The Fed only gave lip service to what this recent round of financial turmoil will imply for the economy (“Recent developments are 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.”). At the same time, to placate the hawks, the statement added, “The Committee remains highly attentive to inflation risks.” It had to do that so that nobody will question whether it has taken its eye off the inflation ball as it moves to the sidelines, which is a base-case scenario. Peak growth. Peak inflation. Peak credit cycle. Peak rates. Buy bonds!
Derek Holt, vice-president & head of Capital Markets Economics, Scotiabank
The US 2-year Treasury yield fell in the aftermath of all of the communications, the dollar depreciated a touch and the S&P500 fell. Some of this reaction was no doubt just as much driven by what the FOMC did not do as what it did do and positioning swings around alternative outcomes.
My overall impression is that what the FOMC did ... is defensible. Too abruptly swinging in either direction could have rocked fragile confidence. That said, it’s all just a bunch of placeholders for now and perhaps there will be greater clarity into the next 1–2 meetings that will inform their stance and future forecasts at the June meeting.
Andrew Hunter, deputy chief US economist, Capital Economics
The 25bp rate hike and new projections unveiled by the Fed today were towards the more dovish end of potential outcomes – with officials acknowledging the likely economic hit from recent banking sector turmoil and leaving their end-year projection for the fed funds rate unchanged at 5.1%, implying only one more 25bp hike from here. Nevertheless, with the crisis making us more confident in our view that the economy will fall into recession soon, we suspect the Fed will be cutting rates again before too long.
The statement acknowledged the potential impact of the banking turmoil, noting that “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation”. Furthermore, despite a more pessimistic assessment of inflation – which is now described as “elevated” (rather than having “eased”) – the statement hints that the end of the tightening cycle is approaching. Rather than anticipating “ongoing increases” in the fed funds rate, officials now only think that “some additional policy firming may be appropriate”.
... Officials appear to have already judged that the recent turmoil will take at least some toll on activity. Nevertheless, with the projection for y/y GDP growth in the fourth quarter of this year being cut only slightly to 0.4%, we suspect officials are underestimating that potential drag. Even before the crisis we thought the economy was at high risk of recession this year and, with recent events likely to hit confidence and result in a significant further tightening in credit conditions we are more confident in that view now. With that economic weakness likely to accelerate the downward trend in core inflation, the upshot is that we still think that the Fed will be cutting rates again before the end of this year, a lot sooner than officials’ own projections now imply.
Royce Mendes, managing director & head of macro strategy at Desjardins Capital Markets
In raising rates, the Fed cited ongoing inflationary pressures in the economy and job gains running at a ‘robust pace’. That said, the statement was noncommittal about what comes next.
While central bankers reassured the public that the US banking system is ‘sound and resilient’, they acknowledged that the recent turmoil would result in ‘tighter credit conditions’. That said, as we’ve been saying, no one knows exactly how much tighter conditions have become – not even the central bank. The Fed stated explicitly said that ‘the extent of these effects is highly uncertain’. As a result, the Committee has pledged to monitor the situation closely to ‘assess the implications for monetary policy’.
The infamous dot plot left the terminal rate forecast of 5.1% unchanged. That said, the accompanying communique didn’t have much conviction regarding that projection. Policymakers now say that ‘additional policy firming may be appropriate, whereas previously they were sure that ongoing rate increases would be necessary.
The only notable change in the dot pot was that Fed officials no longer see as many rate cuts in 2024. The median projection moved higher from 4.1% previously to 4.3%. Policymakers also chose to continue with their quantitative tightening program.
The Fed is clearly doing its best to put on a brave face by raising rates and sticking with quantitative tightening. But the accompanying statement leaves the door open to further stress in the financial system ending this rate hiking cycle prematurely. ...
While this round of stress looks to be well contained, we continue see further bumps in the road. We agree with the Fed that one more 25bp rate hike could be appropriate. However, we see rate cuts happening much more rapidly in 2024. Inflation will likely be lower by then leaving the Fed more scope to focus on the financial stability and full employment parts of its mandate.
Michael Gregory, deputy chief economist, BMO Capital Markets
We still judge the Fed could have one more quarter-point move up its sleeve, before pausing for the remainder of the year in the wake of an unfolding mild recession and further disinflation. This economic scenario is reinforced by the growth dampening impact of banking sector stress and tighter financial conditions.
Taylor Schleich & Jocelyn Paquet, economists with National Bank Financial
Expectations had been drifting towards a 25 bp hike in recent days but today’s rate increase was hardly a foregone conclusion. In our view, the decision to hike was appropriate given still-elevated inflation and the potential that failing to tighten policy might’ve been interpreted as a lack of confidence in the banking system. Overall though, we feel the FOMC struck a good balance here in a tough situation. They were able to convey confidence in the financial system while continuing to combat inflation risks. And at the same time, they signaled that recent events create additional uncertainty and will likely mean tighter financial conditions at the margin. That’s also reflected in the dot plot, which without recent turmoil, would’ve surely seen the dots increase to a greater level. Instead, the rate outlook remains broadly unchanged suggesting that these tighter conditions might be equivalent to a couple of 25 bp rate increases. Markets still anticipate rate cuts before the year is out but we tend to agree with the Fed’s dot plot that doesn’t signal lower rates until at least early 2024. Of course, conditions can change very quickly as we’ve recently learned and it’s not only going to be about inflation/labour market data from here.
Ashish Shah, chief investment officer of Goldman Sachs’ public investing business
We see considerable uncertainty in the path ahead and would downplay the significance of updated economic and dot plot projections in such a fast-moving environment. Going forward, we expect the Fed’s data dependent framework to be informed by what happens in both the economy and banking sector.
Darcy Keith