Overview
What happened
In what was an exceptionally challenging policy decision in light of the ongoing banking turmoil, the US Federal Reserve met market expectations by retreating to a quarter percentage point rise in interest rates at its March meeting. The decision to go ahead with a hike is a clear signal of the Fed’s confidence in its ability to contain financial instability while at the same time keeping its focus on taming inflation.
In its statement, the Fed emphasised that recent developments in the US banking system are likely to feed through to tighter credit conditions, but the impact on growth is uncertain. The panel also continued to signal “some additional policy firming may be appropriate” - notably toned-down guidance for further rate hikes. Policymakers’ future expectations for rates in the “dot plot”, however, show an unchanged median forecast of 5.1 per cent.
Our interpretation
The Fed is following the ECB’s template - hiking while switching to a more cautious meeting-by-meeting approach. The panel could have used ongoing stress in the banking system as a valid reason to take some time out. That would have raised questions around the Fed’s commitment to taming inflation, a risk the FOMC participants decided not to take at this point. Instead, the risk now is that this hike proves counterproductive, further exacerbating concerns about the banking system, fuelling market turmoil, and eventually spelling a worse downturn in the economy.
In the press conference, Chairman Powell sounded cautious, emphasising uncertainty in gauging the effect of banking stress on credit conditions and the associated impact on the economy. He also noted that the tightening in credit conditions may do some of the Fed’s work for it, meaning the policy rate is adjusted less than expected. But he also made clear that if this doesn’t come through, then more hikes will be necessary.
The key message from Powell is that the Fed is now looking at broader measures of financial conditions - not just market-based indicators but also measures of credit conditions, with the bank lending channel playing a central role in the transmission of monetary policy as well as being at the heart of ongoing stress.
Outlook
As the crisis in the banking system continues to unfold, we believe the likelihood of a hard landing scenario - our base case for some time - has risen dramatically in recent days. The current market stress, a symptom of the size and speed of policy tightening to date, is causing wider spillovers through the bank lending channel to the real economy.
As a result, we judge that the probability of a US recession in the next 12-months is now as high as 95 per cent, up from 55 per cent before the banking crisis began. While we remain in the camp expecting a cyclical recession (an 80 per cent probability we believe), we note that the exact impact on growth of the path the Fed is taking is exceptionally hard to judge. The situation remains fluid with much uncertainty ahead. We do, however, stress that risks around our base case scenario are firmly skewed to the downside, with a non-trivial probability (15 per cent) over the next 12 months of a deeper and more serious balance sheet recession.
The Fed’s reaction function remains the crucial determinant of the path from here. Any signs of easing inflation pressures and cooling labour market constraints in coming weeks would be the Fed's saving grace, allowing them to execute the long-awaited pivot and signal the end of the cycle. If inflation remains hot, the Fed will likely attempt to continue the policy of tool separation in order to juggle both price stability and financial stability, trying to convince markets there is no trade-off between them. But given the role of markets and sentiment in policy transmission, this trade-off is alive and well, and if it sharpens, markets will test the Fed until it blinks - and finally exercise the ‘Fed put’.
Asset allocation implications
We still favour a cautious stance expressed through an underweight to credit and an overweight to cash. The end of the Fed’s tightening cycle is drawing near, and we are mindful that this has the potential to cause a relief rally in risk assets in the near term. However, we believe that the significant amount of tightening already enacted, together with slowing growth, high inflation, and now the stresses in the banking sector warrant a defensive approach. We still broadly favour emerging markets over developed ones, although tightening lending standards in the US and Europe are a headwind for emerging market currencies. The China reopening story is still intact, meaning the country could be a useful diversifier if growth stalls or banking stresses intensify.
