Overview
First, a Pause was Discussed but Eventually Dismissed
In days prior to the meeting, committee members considered pausing the rate hiking campaign due to uncertainty with some regional banks. The run on deposits at some banks in the U.S. created a bit of a scare, but as the days passed, participants believed conditions were favorable for increasing rates and markets were stable enough for participants to publish updated Summary of Economic Projections (SEP). Uncertainty in the banking sector created some division among committee members; however, the median rate forecast for 2023 was unchanged from December at 5.1%, but the path for the rest of the year is muddied. Some forecast no more rate hikes, while others forecast quite a bit more tightening.
As risks of contagion seem to diminish, investors should expect the FOMC to focus on the inflation portion of the dual Congressional mandate for price stability and full employment, i.e., the growth component of the mandate. Unlike the Great Financial Crisis, larger banks are currently well-capitalized and hedged against broader economic risks, giving the Fed room to hike rates amid the volatility.
Second, Tighter Financial Conditions are Equivalent to a Hike in Rates
The Fed may not have to raise rates as much as they expect if financial conditions tighten, since tighter conditions translate into equivalent rate hikes. Although broader financial conditions are tighter now, the Fed will likely stay vigilant with fighting inflation. Given the recent deceleration of prices across much of the economy, the Fed can rightly soften their language about future rate increases from a commitment to a possibility.
As shown in the chart below, financial stress spiked from the uncertainty in the banking sector, and will likely put a damper on the economy, and as the economy slows, consumers pull back spending, and aggregate demand falls, the Fed may not have to hike as much as they anticipated just a few weeks ago.
Third, Fed Officials do not Expect to Cut Rates this Year.
The markets are at odds with Chairman Powell and his colleagues. The FOMC does not plan on cutting rates this year, but the markets seem convinced the committee will indeed cut rates. Who is right? The markets are probably right because the impact of tighter financial conditions, softening consumer demand, and a slowing economy will release some of the inflationary pressure. Our view is that inflation will be in the mid- to upper-3% range by end of year and will likely slow further next year.
Inflation fighting is still the Fed’s main focus and therefore, it behooves the committee not to pencil in any rate cuts at this point of the cycle. But both markets and the FOMC can agree on at least one thing—the outlook for inflation the rest of the year looks promising.
Supporting the “higher for longer” view is that the banking failure of Silicon Valley Bank seems to be contained and the general financial system appears stable. Although we expect a final 0.25% increase in the Fed’s target rate at the next meeting, the economy is weakening so conditions look like our baseline forecast this year will come to fruition. That is, the Fed pauses by the summertime and the economy ekes out slightly positive growth for 2023.
What Does It Mean for You?
Policy makers view the banking sector as sound. And further, during the press conference, Chair Powell emphatically communicated that the crisis within Silicon Valley Bank was an outlier, not a harbinger of more banking failures. Contagion risks are dissipating but still, the localized crisis has tightened financial conditions and increased recession risks this year. If the economy slows, the Fed may not have to raise rates as much as they had anticipated. In the near term, markets should respond favorably to the updated outlook and the latest decision. Investors’ wishes may come true—contagion risks are low enough for the Fed to hike rates and inflation pressures are soft enough for the Fed to be near the end of the rate hiking campaign. LPL Research remains cautiously constructive on equities, though gains for this year may be more back-end loaded.
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IMPORTANT DISCLOSURES This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing. Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results. Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy. Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.
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