At today’s meeting the Federal Reserve addressed two distinct issues: financial stability risks and inflation risks.
Financial Stability
With regard to financial stability, Chair Powell had a clear and forceful message. Here are Powell’s words (emphasis added):
“The Federal Reserve, working with the Treasury Department and the FDIC, took decisive actions to protect the U.S. economy and strengthen public confidence in our banking system. These actions demonstrate that all depositors' savings in the banking system are safe.
Our banking system is sound and resilient with strong capital and liquidity. We will continue to closely monitor conditions in the banking system and are prepared to use all of our tools as needed to keep it safe and sound.”
In normal times such comments may not warrant much attention. In the context of the ongoing challenges facing the US banking system, however, Powell’s comments carry added significance. His implicit guarantee of depositors in US banks is particularly important. Implicit guarantees help restore confidence. They help stop deposit outflows. And they commit policymakers to following through with actions, should that become necessary.
Policymakers responded swiftly and forcefully to the recent failure of two medium-sized banks. Nonetheless, concerns about financial stability have persisted. Market pricing suggests those concerns continue to linger: the sharp fall in short-term interest rates largely reflects a concern about financial stability risks, rather than a change in the economic or inflation data. In addition to reassuring depositors, Powell’s comments were also aimed at assuaging these lingering concerns.
Chair Powell also touched on two other aspects of the Fed’s program on financial stability. He highlighted the Fed’s capacity to provide liquidity to the banking system, including through the emergency Bank Term Funding Program (BTFP) and the discount window. These facilities have already provided a lifeline for banks experiencing deposit outflows, and Chair Powell signaled more is available as needed. Chair Powell also spent quite a bit of time discussing the capital adequacy of US banks. While the banking system overall has a substantial amount of loss-absorbing capital, a few banks have large unrealized losses relative to their capital buffer. The banks in question are smaller and regulated differently than the largest banks. Chair Powell strongly hinted that these differences in regulation would be reassessed and changes would be made, if deemed appropriate.
Taken together, we think Chair Powell’s comments today are a useful step toward restoring confidence in the US banking system. There is a possibility that more policy actions will be needed in the coming weeks and months. But with such resolute commitments from the Fed Chair in place, the chances of successfully navigating this current challenge are substantially more favorable than they would otherwise be.
Inflation and Monetary Policy
The Fed also addressed the inflation risks today. The Fed raised interest rates by 25 basis points, making today the ninth straight meeting in which rates were increased. One thing that made today’s hike somewhat different from previous moves is that markets were less than fully priced for it prior to the meeting. And just a few days ago the probability of a hike was below 50 percent. By pushing forward today, even given pricing and the ongoing banking risks, the Fed demonstrated resolve in its effort to bring down inflation.
In the press conference, Powell’s hawkish rhetoric regarding inflation was very much as it has been. Chair Powell reiterated his usual statements about inflation being too high, inflation causing substantial hardship for Americans, and the Fed remaining committed to restoring price stability. Today’s statements sounded as hawkish as any Powell has made over the past year. Chair Powell does not appear to be alone in his concern about the inflation risks. Many meeting participants increased their forecasts for inflation relative to last December’s forecast, and nobody on the committee appears to have decreased his or her forecast for interest rates.
At the same time, there were hints from Chair Powell that the increases in interest rates may be coming to an end. For example, the committee downgraded the forward-looking part of its official statement. Last month the Fed statement said “ongoing increases will be appropriate”. Today’s Fed statement used a softer verb and said “policy firming may be appropriate” (emphasis added).
In his comments on the economic outlook, Chair Powell acknowledged an increase in uncertainty. Indeed, there are substantial cross-currents at the moment. On the one hand, last month prices rose faster than expected and employers continued hiring workers at an elevated rate. These economic data suggested upside risks to the outlook. On the other hand, recent shocks to the financial system will likely slow future credit creation and could adversely affect confidence. The shocks have clearly introduced a new source of downside risk to the outlook. Rather than taking a convicted stance on these risks, the Fed opted for a more careful approach and simply acknowledged that it was unclear how exactly the opposing risks would play out.
Conclusion
Today’s Fed meeting had an exceptional number of moving pieces. Powell’s comments on financial stability were an important contribution that could work to reduce the risks facing US banks over time. The increase in interest rates, together with the normal hawkish rhetoric on inflation, indicated the Fed believes it is far from its goal of restoring price stability. And yet the softer forward-looking statement and the acknowledgement of uncertainty could signal a potentially more cautious approach going forward.
On the day, it appears that investors placed the most weight on the final consideration, and that they interpreted that to mean the forward rate path may be lower than previously believed. Our own view is somewhat at odds with that one-day price action. We think that Powell’s comments on financial stability are likely to be more consequential. If the Fed is successful in stopping the banking panic, it is unlikely that the other economic considerations would justify cutting interest rates this year. Instead, in the absence of a banking panic, short term interest rates may end up more closely following the path laid out in the Fed’s forecasts. We think Chair Powell increased the odds of such an outcome with his comments today.