Don’t Bank On It

The Federal Reserve (Fed) did the sensible thing at its March Federal Open Market Committee (FOMC) policy meeting, and Chairman Jerome Powell delivered a sensible message, in my view. Financial markets gave it a very dovish interpretation, which to me seems off the mark, and which once again diverges sharply from the Fed’s own policy forecasts. There is a substantial degree of cognitive dissonance in the markets’ reaction, as I will argue below.

The Fed raised its policy interest rate by another 25 basis points (bps), to a target range of 4.75%-5.00%. Powell noted that inflation is still too high and the labor market still too hot; he also recognized that the recent turmoil in the banking system seems likely to result in some contraction in credit conditions, which would have the same impact as more rate hikes and therefore would leave less need for additional policy tightening. The Fed consequently weakened its language on future rate moves, from envisioning “ongoing increases” in policy rates to saying that “some additional policy firming” may be needed.

By how much will credit conditions tighten because of the banking sector tensions? The Fed does not know, and neither does anybody else. At this stage, this is the pivotal uncertainty.

Powell however made a strong case that Silicon Valley Bank (SVB) and Signature Bank are very special cases, that their vulnerabilities, mismanaged interest-rate exposure—and in SVB’s case at least—excessive concentration of their deposit base, are not mirrored in any significant number of other financial institutions, and that the US banking system as a whole is in very solid shape. Several recent analyses of the US banking system confirm this assessment. Notwithstanding this, we might still see some credit tightening as banks take a more cautious stance to protect themselves from the risk of deposit outflows, however unlikely. But with the US economy still growing at a robust pace, a moderate credit tightening seems a lot more likely than a full-fledged credit crunch.