Fed Hikes Interest Rates but Maintains a Soft Tone with Banking Shock Seen as Positive for Inflation

The Fed hiked interest rate by a quarter point at yesterday’s meeting but hinted also that they keep their options open for more hikes because inflation remains significantly above the target level. The tone of the statement was clearly softer, just remember that in the February meeting, the wording regarding future rate hikes was more definite ("further increases will be appropriate" instead of "may be appropriate"). The market reaction was mixed - the FOMC decision and Powell's comments caused both the stock market and the dollar to plummet. At the press conference, Powell stated that the banking sector shock worked as a rate hike and should have a positive impact on inflation as well as slow down activity in the economy. In addition, as a result of the banking stress, various borrowing rates have increased and credit availability has decreased, which, in Powell's opinion, allows us to equate the effects of the banking shock to the effects of monetary tightening and means that the Fed will have to do less work in this direction.The dollar fell by an average of 1% against major currencies after the FOMC decision:The two-year bond yield fell by 20 basis points, and the ten-year bond yield by about 10 basis points. Gold prices rose by more than 1.5%, reaching $1,980 per ounce today. According to futures on the Fed's interest rate, investors expect the rate to be 50 basis points lower than the current level with a probability of 1/3 and 25 basis points lower with a probability of about 1/3. The median rate according to the Dot Plot remained at 5.1%, which corresponds to December's expectations, with a consensus forecast of 5.4%. In other words, the outcome of the meeting turned out to be more "dovish" than expected. Overall, the Fed yesterday seemed confident that the shaky banking sector, due to the extraordinary rapid rise in interest rates, would not lead to the destabilization of the economy. This can be concluded from Powell's comments ("The banking system is strong and stable"), as well as unexpectedly strong forecasts for key macroeconomic indicators. The GDP forecast for the fourth quarter of 2023 was reduced by only 0.1%, from 0.5% to 0.4%, and in 2024 - from 1.6% to 1.2%. The Fed left inflation and unemployment forecasts practically unchanged. Interestingly, the Fed now expects a rate cut of only 75 basis points in 2024, compared to 100 basis points in December 2022. Powell followed in the footsteps of Christine Lagarde and made it clear that he separates issues of financial stability from the fight against inflation and has tools to work on both fronts. This means that bank panic and even defaults in the banking sector won't be able to easily derail the Fed's policy tightening. Therefore, the Fed can combine both easing and tightening policies. As the panic in the banking sector subsides, it's likely that risk-taking behaviour will increase, given that major US economic indicators point to the economy remaining in good shape. Labour market data, retail sales, and an uptick in CPI in February are all important bullish indicators. However, as market optimism returns, there will be corresponding pressure on the Fed to continue hiking rates.To gauge the health of the economy and the banking sector, it's crucial to keep a close eye on indicators of credit availability, bond short-term market rates, and the Fed's balance sheet. The Fed's balance sheet has become a proxy for stress in the banking sector, thanks to newly established lending facilities such as the BTFP, which allows US depository institutions to tap into Fed funds if they face a sudden outflow of customer deposits. Recent data reveals that the balance sheet rose sharply by $200 billion, reflecting the banks' demand for funds:If this trend continues, it could be a sign of a lack of credit availability, which would put pressure on both risk assets and bond market rates. As such, keeping an eye on the Fed's balance sheet has become an important tool for assessing the health of the banking sector and the broader economy. Investors should also pay attention to how actively banking sector players are tapping funds from swap lines from the Fed and other major central banks.