May 7, 2023|Market Insights- 4 min
This article provides an overview of the context and reasoning behind the latest decision of the Fed and the potential implications for investors.
The decision and the data
The latest increase is the tenth consecutive rate rise since the Fed began to tighten monetary policy last year. Interest rates have increased from near zero in March 2022 to 5.00-5.25%, the highest in 17 years.
Notably, the statement omitted the “anticipated” additional policy firming of the March statement. Instead, it asserted that it would “determine the extent to which additional policy firming may be appropriate.”
In the follow-up question-and-answer (Q&A) session, Fed Chairman Jerome Powell clarified that “a decision on a pause was not made today” and that the Fed is “prepared to do more if greater monetary policy restraint is warranted.” This was intended to counter the widely held view that this would be the last rate increase before monetary easing resumes.
The statement of the Fed and Chairman Powell's follow-up comments reflect the mixed, but generally improving, data on inflation since the last meeting.
The Consumer Price Index shows inflation declining from an annualized 6% in February to 5% in March, its lowest in nearly two years. Energy prices contributed to this decline with gasoline prices 17.4% lower than a year ago.
However, the Personal Consumption Expenditure price index, excluding food and energy, declined just 0.1% over the same period, indicating that other costs (e.g. rent) are proving more stubborn.
Meanwhile, the tight labor market continues to drive inflation. Private payrolls increased by 296,000 during April, more than double the Dow Jones estimate of 133,000, and the steepest monthly rise since July 2022. Worker compensation continued to grow at 1.2% in Q1 2023, compared to 1.1% in Q4 2022.
Signs in the broader economy point to slowing growth. Real GDP growth dropped to 1.1% in Q1 2023 from 2.6% in Q4 2022. This trend is significant, as lower demand should decrease pressure on prices, and therefore reduce inflation.
Latest news from the banking sector
The health of the banking industry plays a crucial role in the rate decisions of the Fed, as a stable banking system is essential to maintaining economic growth and controlling inflation.
Before the last Fed meeting, concern was growing that US regional banks were on the brink of a serious crisis. The US government acted to reassure depositors, and the damage appeared at first to be isolated to a group of banks that had made poor strategic decisions (Silicon Valley Bank, Signature and Silvergate).
The closure of First Republic Bank on May 1 following revelations that it had lost $100 billion in deposits during the previous month renewed the fear of wider contagion. Shares in regional banks, like PacWest, Western Alliance Bank and KeyCorp, suffered following the announcement as investors feared large-scale deposit outflows.
In its report on the issues that led to the shutdown of Silicon Valley Bank, the Fed noted that social media and technology may have ”fundamentally changed the speed of bank runs,” which now can occur in hours rather than days. This means that actions by the Fed yields more immediate effects compared to previous years.
During the Q&A session, Powell conceded more generally that credit tightening complicates the assessment of the committee and adds uncertainty. Independently of interest rates, a banking crisis could further dampen inflation and intensify a potential recession.
How markets have reacted
While markets expected the decision of the Fed, its implications on the US economy and further rate hikes (or reversals) in the months ahead were less clear.
The Dow Jones Industrial Average ended the day of the announcement down 0.8%, and the S&P 500 and the Nasdaq Composite dropped 0.7% and 0.5%, respectively. This may have been a reaction to indications by Powell that rate cuts were unlikely this year. Short- and long-term Treasury yields also moved lower, reflecting a belief that rate increases are ending. In line with these expectations, the US dollar index also fell 0.42% on the day.
Looking ahead, the FedWatch tool indicates that markets predicted a 0.5% to 1% drop in interest rates before year-end, despite Powell's cautious signaling. This probably indicates a belief that a recession would trigger a rapid reversal of interest rate policy.
Tom Garretson, a strategist at the RBC Portfolio Advisory Group, characterizes the move as a “dovish hike,” noting that the updated policy statement suggests a high bar for further rate hikes.
Powell’s statement made little in the way of commitments and invoked a “wait and see” (what the Fed calls “data dependent”) approach. This is difficult to debate and leaves relatively little room for experts to comment.
What does this mean for investors?
Short-term predictions are often more challenging than long-term forecasts.
Events such as a gridlock on US debt ceiling talks, or an unexpected acceleration of the Ukraine war, could confound the most careful analysis.
The Fed Committee reached a strong consensus on the latest move, but its March forecasts reveal growing internal debate about the direction of interest rates.
Hence, investors should focus on the economic fundamentals driving the value of their assets.
The prospect of a recession is higher following the banking crisis. In a recent interview, former US Treasury Secretary Larry Summers estimated a 70% likelihood of a recession in the next 12 months.
While this would fall short of the coveted ”soft landing” (lower inflation and continued economic growth), a mild or so-called “growth recession” is still possible, where employment remains relatively strong despite a weaker economy.
Maintaining a balanced view amid panicked markets facing a constant stream of bad news is the hallmark of a successful long-term investment strategy.
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