The Federal Reserve has once again raised the Fed funds target range by 25 basis points, taking it to a new high of 5.00-5.25%.
This latest move was in line with both the market and economist consensus, bringing the FOMC in line with their 2023 year end dot plot projection. While Chair Powell did not explicitly announce a pause, noting that the decision to do so would be made in June, the changes to the rate statement suggest a pause is highly likely.
The lead-up to this latest announcement was dominated by a renewed emergence of bank stability worries following the failure of First Republic on May 1st, and concerns around whether the Federal debt ceiling would be raised. Despite this, with inflation still running way above target, policymakers chose to further tighten financial conditions. This was not a surprise to us, nor to markets. With expectations for this most recent hike having been firm for some time, the playbook for raising rates is now well established: don’t disappoint the consensus, else markets may think you have something to hide. As such, the market reaction in the immediate aftermath of this latest move was unsurprisingly muted.
Digging into the detail, the statement accompanying this latest decision alluded to the impact that banking concerns are having on the US economy, and on the thinking of Fed members, retaining text introduced in the last release that the “US Banking system is sound and resilient”.
More importantly, in a change of language, it appeared to confirm that financial instability worries were now definitively weighing on credit conditions, with the language altered to imply that the Fed has seen credit conditions tighten, but that the impact on economic activity remained uncertain. This appears to have played some role in perhaps the most meaningful change in Fed communication, which removed stronger language that suggested a bias towards future tightening. Instead, the statement merely said: “In determining the extent to which additional policy firming may be appropriate to return inflation to two percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” This was a significant move away from previous messaging that considered “the extent of future increases,” although it still retains a bit of a hawkish tone. We view the new language as foreboding a pause at future meetings, especially since Chair Powell explicitly drew attention to the change of language in the statement during the press conference.
Fed Chair Powell puts a pause on the table, even if he tried to avoid saying it
While we think the FOMC statement hints towards an end to this hiking cycle, Fed Chair Powell neither confirmed nor rejected this interpretation when journalists pressed him for an explicit answer. Instead, he noted that “we are prepared to do more if greater monetary restraint is warranted” but which maximises the Fed’s optionality while sounding like they are close to where they want to be, especially given the tone with which Chair Powell said it. This was reinforced by Powell’s reference to data dependence and the importance of moving “meeting-by-meeting”, which is central banker code that, in the context of slowing inflation and growth, the Fed would prefer to be done with interest rate hikes. This change in emphasis seems to be driven at least in part by the tightening in credit conditions, both from higher monetary policy and from financial stability concerns, a topic that dominated the press conference. The Fed Chair repeatedly highlighted that, while it is now clear that the developments in the banking sector have led to tighter lending standards, the degree of tightening and its economic impact are still uncertain. In response to a question about the content of the upcoming Senior Loan Officer Survey, which is released next Monday, Powell pointed to small and medium sized banks that were looking to apply stricter lending standards and shore up liquidity as a causal factor.
Looking ahead, the main message from today’s communications was that everything is under review and subject to change.
Given high levels of uncertainty, Powell said that there would be an ongoing assessment of economic conditions, the effects of credit tightening, and the appropriate policy stance. Providing an unusual level of insight into the Fed’s reaction function, Chair Powell revealed that once inflation is down to 3%, the importance of both sides of the dual mandate would be balanced. Currently, the focus is still on inflation given that the labour market is exceptionally tight and inflation is well above target. He further noted that, while inflation is expected to fall to this level by the end of 2023, wage growth would need to fall from roughly 5% to around 3% for the Fed to be confident that core inflation pressures are contained. Most importantly, this was framed in the context that only a few more months of data would be sufficient for the FOMC to be confident about whether policy was sufficiently tight. With inflation now trending in the right direction, and only six weeks between now and the June meeting, we think it is likely that the data will allow the Fed to hold rates in June.
A final key point that Powell made during the presser was about the debt ceiling: he was very firm in warning Congress that if the US failed to pay its bills, the consequences would be dire.
What we view as the most important takeaway from this announcement is the lack of a market reaction. Treasuries fell only a few basis points from pre-announcement levels, and the DXY dollar index was largely unmoved. Whilst this can be partly explained by a Fed decision that met expectations, it also suggests a greenback that has increasingly moved on from shifts in monetary policy as a driver of value, and towards considerations around the longer-term outlook for interest rates and economic growth. However, with credit conditions driving increased uncertainty, the potential for surprises and therefore dollar volatility look set to pick up in the coming months.
Minimal market volatility following rate decision as nothing surprising was said
Jay Zhao-Murray, FX Market Analyst
Nick Rees, FX Market Analyst