The Federal Reserve’s Federal Open Market Committee (FOMC) on Wednesday raised the target policy interest rate (the federal funds rate) to 5.00 percent, an increase of 25 basis points. With this latest increase, the target has increased 4.75 percent since February 2022.
However, with an increase of only 25 basis points, the March meeting is the second month in a row during which the Fed has pulled back from its more substantial rate hikes of 2022. After four 75-basis-point increases in 2022, the committee approved a 50-point increase in December, followed by a 25-point increase in February, and another on Wednesday.
Although CPI inflation remains at or above six percent, the FOMC has slowed down in its monetary tightening over the past two months. At Wednesday's press conference, Fed chairman Jerome Powell moved further into dovish territory.
We should expect more of this as the year wears on. Although CPI inflation remains well above the Fed's two-percent target, recent bank failures will put the Fed under pressure to force interest rates back down so as to give banks better access to cheap liquidity. In other words, the Fed will have to choose between helping bankers on the one hand and reducing inflation for regular people on the other. Experience suggests the Fed will side with bankers and will thus move back in the direction of easy money even as inflation continues to drive up the cost of living.
The Fed Can't Keep Tightening and Also Protect Banks
The FOMC's retreat to 25 basis points was expected in light of this month's bank failures and nascent financial crisis which became obvious with the failure of Silicon Valley Bank on March 10. This was the largest bank failure since the 2008 financial crisis, and is the second-largest bank to fail in the United States. On March 12, Signature Bank failed as well.
In order to prop up the banking sector in the wake of these failures, the Fed is unlikely to continue with much more than token monetary tightening. Here's why:
As SVB and Signature Bank failed, depositors who exceeded the $250,000 maximum for FDIC deposit insurance were poised to lose the entirety of their deposits above the maximum. In the case of both banks, this was the lopsided majority of depositors. Many policymakers became fearful that system-wide concerns over bank failures among depositors would cause mass withdrawals from the banking system—especially among smaller banks.
This would have pushed even more banks toward insolvency, and would have been highly deflationary. In what has become nearly normal since the 2008 bailouts, both the Treasury Dept and the Federal Reserve sought to intervene in markets to backstop banks and provide a de facto bailout. This came in the form of a March 12 joint announcement from both Treasury and the Federal Reserve that virtually all deposits—regardless of the $250,000 legal limit—would now be guaranteed. Federal policymakers claimed that this would be financed by FDIC fees, but this is clearly wishful thinking since total deposits at US banks exceed FDIC funds by about $18 trillion. Moreover, the Fed has promised to further prop up bank portfolios by allowing banks to receive loans against collateral at fancifully high par values, rather than at market value.
[Read More: "Yes, the Latest Bank Bailout Is Really a Bailout, and You Are Paying for It." by Ryan McMaken]
Yet, even with these new special favors doled out to bankers and wealthy depositors, banks will continue to head toward even more precarious positions if the Fed continues to allow market interest rates to head upward.
The Fed's Low-Interest Bubble
Thanks to more than a decade of negative and near-negative real interest rates, the banking sector has become extremely reliant on business models that assume extremely low interest rates. If interest rates continue to head upward, banks will increasingly find themselves in a position of having to pay out interest at higher rates than they can collect on the older low-interest assets on teh banks' balance sheets. In other words, banks will find themselves with negative cash flow and will become insolvent.
[Read More: "How Easy Money Killed Silicon Valley Bank" by Daniel Lacalle]
Moreover, even if the Fed pivots back toward easy money, many banks will continue on the road to failure anyway, and this will necessitate new bailouts via the sorts of quantitative easing we saw after 2008. That too will require lowering interest rates to be sustainable beyond the very short term.
Considering the fragility of the financial system, and the potential need for more bailouts, it's hard to see how the Fed can really continue with the ongoing quantitative tightening that Powell has repeatedly claimed he will support.
How the Fed Got More Dovish on Wednesday
We can already see how the Fed is backing off from Powell's relatively hawkish talk over earlier months. For example, in February's press release, the FOMC noted:
The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.
In contrast, this is what Wednesday's statement reads:
The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.
We see that "increases" has become "firming"—i.e., holding steady on increases—while "will be" has become "may be." "Ongoing" has become "some." In the press conference, Powell explicitly noted that readers should focus on "some" and "may" as the key part of this sentence.
As has been the case since the Fed abandoned forward guidance and any attempts to claim it has a long-term plan, the FOMC was sure to state "the Committee will continue to monitor the implications of incoming information for the economic outlook."
In other words, FOMC policy and outlook could change at any time.
In spite of the FOMC's clear lack of commitment on any particular policy, many will continue to look the FOMC's "dot plot" (in the Summary of Economic Projections or SEP) as indicators of future Fed policy. In Wednesday's new SEP, the dot plot suggested that all but one member of the FOMC say they expect the target interest rate to remain above five percent this year. All but four members say they expect the target rate to remain above four percent through next year.
For those looking for reliable information on the future, however, they'll find little of it in the SEP. Experience makes it clear there is very little correlation between what Fed officials say will happen, and what actually does happen. After record breaking amounts of monetary inflation in 2020 and 2021, Fed economists were still insisting that price inflation would be no problem and would be "transitory." Numerous Fed economists from Neel Kashkari to Jerome Powell continued to state that the Fed should keep interest rates low well into 2022, or even into 2023.
They were wrong about both inflation and Fed policy. There's no reason to assume that FOMC members provide a reliable gauge of future policy.
Moreover, the SEP's predictions of future economic conditions read more like an attempt at calming fears over recession and inflation. For example, the SEP predicts the US economy will grow by 0.4 percent in 2023, and 1.2 percent in 2024. In other words, the SEP is clear that if there is any recession in 2023, it will be neither long nor deep. The SEP also takes it as a given that inflation will come down substantially in 2023, predicting a median rate of 3.3 percent in PCE inflation. It's hard to not read this as wishful thinking, and it would be very much in character for the Fed which tends to paint a rosy picture of the economy until recessions become undeniable.
Not surprisingly then, Powell at Wednesday's press conference continued the Fed's policy of fixating only on the relatively innocuous employment data while ignoring a number of other economic indicators that point to recession. Moreover, when asked about the likelihood of a "soft landing," Powell insisted it is still possible, and concluded it is “too early to say whether these events [i.e., bank failures] have had much of an effect.”
Unfortunately for ordinary people who are seeing real wages fall, the Fed is being careful to keep the door open for more bailouts and financial repression in the interest of bailing out Wall Street and the financial sector yet again.
What remains unclear is whether the Fed will favor bankers by forcing interest rates back down, or simply by turning to bailouts once a financial crisis is obvious. Or, it could be a mixture of both. In none of these cases, though, is the Fed committed to any real efforts to bring inflation under control. Unless the Fed does more to rein in inflation soon, a likely outcome will be recession plus price inflation. This sort of stagflation would be devastating to American households. I have no doubt, however, that bailed-out bankers and wealthy depositors will weather the economic storm much more easily.
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