May Fed meeting: Hike and watch

Executive summary:

• With today’s 25-basis-point rate increase, the U.S. Federal Reserve (Fed) has now hiked rates by a cumulative 500 basis points since March of 2022
• Whether the Fed hikes rates again in June or goes on pause will likely depend on the labour market and the decline in inflation
• Chair Jerome Powell has made it clear that taming inflation remains the Fed’s number-one goal, even if that leads to a U.S. recession. Because of this, we see recession risks as elevated.

The U.S. Federal Reserve hiked interest rates by a quarter point today, potentially cap-stoning a tightening cycle that has rocketed U.S. overnight interest rates up by a cumulative 500 basis points, away from the zero lower bound since last March.

Is the Fed hitting the pause button?

Today’s hike was widely anticipated, with fixed income markets pricing a 90% probability on the outcome. Most investors were focused on what guidance they could glean about the Fed’s interest rate strategy going into June and beyond. Basically, was this the last rate hike for the cycle or not?

The Fed took a page out of its June 2006 playbook in signaling a pause today. Here’s a side-by-side:

“In determining the extent to which additional policy firming may be appropriate, the Committee will take into account…economic and financial developments.” – May 2023.

“The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth” – June 2006.

Source: Board of Governors of the Federal Reserve System.

That’s textbook Fed to send a signal and preserve optionality. The next decision in June will hinge on the performance of the U.S. economy between now and then. If the FOMC (Federal Open Market Committee) sees more evidence that the labour market is cooling down and more evidence that inflation is on a glidepath back toward 2%, then this hike will likely be the last. If the FOMC doesn't see this, they will likely hike again. It’s hike and watch – it’s data dependence – it’s normal.

Ultimately, this was not a hawkish pause or a dovish hike. It was right down the fairway: textbook central banking.

How are banking issues impacting the outlook?

While most investors were focused on the Fed’s forward guidance – which is clearly important – we were arguably as interested, if not more interested, in what Chair Powell had to say about recent developments in the banking system. This is because the Fed has better and timelier data on the banks than investors do, including data on the degree to which banks have tightened their lending standards in the wake of the Silicon Valley Bank failure. Powell had that information to inform today’s decision; we get it next Monday. He indicated in the press conference that the strains from the banking crisis in early March “appear to be resulting in even tighter credit conditions for households and businesses.”

Recession risks vs. inflation concerns: The dilemma facing the Fed

Central banking is not a precise science. The Fed’s decisions are made based on conflicting signals about the current health of the economy, very uncertain forecasts about the economy’s future and knowing any decisions it makes will not be fully felt for months. It’s a herculean task. Because of the imprecision involved, decisions – in practice – are made through a risk-management lens.

And the decisions facing the central bank are table-stakes. Does Powell prefer to raise rates too high – to get inflation under control while risking a recession along the way? Or, does he prefer to err on the side of caution, prioritising economic growth but risking another wave of damaging inflation?

The bottom line: Taming inflation is the Fed’s #1 priority – even if it triggers a recession

We know – from repeated public statements – that Powell is emphasising the former. He is committed to getting inflation back down to 2% and is willing to risk a recession to make that happen. Case in point: he hiked rates in March despite his staff of more than 400 Ph.D. economists telling him that a recession was likely later this year.

That risk management context is critical here and part of why we think recession risks are elevated. Overtightening is not the mistake the Fed is worried about making.