ACTV - Fed Preview: How Powell Will Balance Bank Stability Concerns And Inflation Threats

2023-03-21 17:07:28 ET

Summary

• One of the Fed's mandates is financial stability. Another one of its mandates is price stability.
• The Fed needs to convince markets that it's able to competently execute on both mandates without sacrificing one of the other.
• In this article, I anticipate the Fed's policies and communications strategy to strike the right balance.

There are two main things that are currently dominating the thoughts and deliberations of the members of the Federal Open Market Committee: 1) Bank sector crisis, 2) Inflation.

Investors need to be focused on any information and/or hints about which of these two concerns the Fed is prioritizing in their deliberations about monetary policy.

In this article, I'm going to review some of the key considerations that will likely be influencing the Fed's deliberations during its two-day meeting. I also will be sharing what I expect will be the substance and tone of the Fed's policies, which will be announced on Wednesday through prepared statements and through Chair Powell's press conference.

Fed Monetary Policy is Not the Same as Fed's Bank Stability Functions

As I discussed in my most recent article , the root cause of the current US banking sector crisis is the vulnerability of the system to "runs" by depositors - particularly by large customers with uninsured deposits. The Fed's interest rate policy has no impact on which deposits are insured nor on the incentives for large clients to withdraw them.

Some people might argue that the problem was "caused" by unrealized losses in the bond portfolios of some banks and that these losses were the product of the Fed having raised interest rates. This is false. Long-term bond yields may well rise significantly above where they were at their recent peaks - i.e. long-term bond prices might have crashed even more - if the Fed had not raised interest rates as high as it did, in response to inflation.

Indeed, the absolute worst-case scenario for US bank stability is for long-term inflation expectations to rise significantly, thereby causing massive losses on long-term bonds and long-duration credit (e.g. mortgage loans). This disastrous scenario will materialize if the Fed's monetary policy is insufficiently tight to bring inflation down to the 2.0% level that bond markets currently expect.

By looking at the TIPS break-even rate - the 5-Year, F-Year Forward Inflation Expectations Rate is currently at 2.14% - we can clearly see that global bond markets have been granting "the benefit of the doubt" to the Fed regarding bringing inflation back down to 2.0%. However, the Fed cannot take this faith for granted. If global bond markets start to sense that the Fed is not truly determined to deliver on the promise of 2.0% inflation, long-term inflation expectations will sky-rocket, and long-term bond yields will surge higher. At that point, the duration-associated losses (unrealized and realized) for US banks would become far worse than they recently were.

Powell and FOMC members understand how disastrous it would be for the US financial system if long-term inflation expectations rose significantly.

Therefore, I expect that one of the main things that Powell is going to do on Wednesday is to try to draw a very clear line separating the Fed's monetary policy designed to control inflation (Federal Funds rate and open market operations such as QT) and Fed policies to promote stability in the banking system (e.g. discount window and other liquidity-providing mechanisms). The Fed needs to separate these functions in the minds of financial markets participants and it needs to be seen to offer competent solutions for both key tasks.

I expect Powell to send a strong message that the Fed is committed to the 2.0% inflation target. This means that the Powell will emphasize that the Fed is ready to deliver additional interest rate hikes in the future if inflation does not start falling more quickly and/or if labor market conditions do not soften. Furthermore, I believe Powell will once again signal that, pursuant to its 2.0% inflation goal, the Fed is prepared to raise interest rates even if this would trigger a recession in the US.

At the same time, I expect Powell to emphasize that the Fed has a host of tools at its disposal - that are unrelated to the Fed Funds rate or QT - which it can employ to promote the stability of the financial system. For example, he will discuss the Fed's discount window, emergency liquidity facilities.

The Banking Sector Crisis has Tightened Financial Conditions

One of the likely effects of the banking sector crisis will be that credit standards at US banks will become more restrictive and overall credit growth in the US economy will be reined in. Therefore, the monetary tightening caused by the current banking sector crisis is probably equivalent to interest rate hikes of 100 basis points or more.

In this context, Powell will probably emphasize that given the tightening of financial conditions, the Fed can afford to pause while it observes the overall impact of tightening financial conditions on the economy.

Will the Fed Sacrifice Inflation Goals for Banking Sector Stability?

I expect Powell to clearly state that the goals of 2.0% inflation and banking system stability are separate and that they will be addressed by the Fed with separate instruments. However, actions speak louder than words. Financial markets will be sensitive with respect to Powell's exact words, and the "tone" of his remarks, regarding the extent to which the banking sector crisis will influence the Fed's monetary policies - particularly the Fed Funds rate and QT. It's precisely through the Fed Funds interest rate and the Fed's quantitative policies (QT and QE) that the Fed primarily seeks to achieve its 2.0% inflation goal.

Will the Fed Raise Rates by 25 Basis-Points or Hold?

Markets are currently pricing in an 85% probability of a 25 basis-point rate hike at the March meeting. They are, furthermore, pricing in a 57% probability of an additional 25 basis-point hike in May.

My own personal policy preference would be for the Fed to stay "on hold" for this meeting and to condition further rate increases to the evolution of future conditions, as they unfold. The future course of inflation is not going to be impacted by 25 basis points in the Fed Funds rate. However, by contrast, conditions in the banking system are currently very fragile.

Notwithstanding my own personal preference, I think that the Fed will raise the Fed Funds rate by 25 basis points at this meeting and signal that future decisions will be taken on a "meeting-by-meeting" basis depending on how events unfold. In particular, the Fed will be looking at inflation data, conditions in the labor market and overall financial conditions.

Conclusion

The Fed cannot appear to be insensitive to the ongoing banking sector crisis. For this reason, I expect that Powell will signal that after raising the Fed Funds rate by 25 basis-points at this meeting, any future interest rate increases will be considered on a "meeting by meeting" basis, while it monitors overall macroeconomic conditions, including developments in the banking system.

At the same time, I expect Powell to emphasize that being on a "meeting-by-meeting" basis does not imply any sacrifice of the Fed's 2.0% inflation goal, since the banking sector crisis has actually brought about a tightening of financial conditions that is equivalent to several interest rate increases. I expect that Powell will also state that the Fed stands ready to increase interest rates in the future if there are any disappointments in the inflation data or if labor market conditions do not soften.

Regardless of what their expectations are going into a "Fed day," investors and traders need to stay flexible and open-minded. At Successful Portfolio Strategy, we're prepared to take action on our portfolios in accordance with developments that occur in real time. In the current context, with a banking sector crisis brewing, a potential recession on the horizon and numerous national and international risk factors looming it's important to be active in managing unique risk and opportunities in portfolios at this time.

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