The Federal Open Market Committee (FOMC or Fed) raised its policy interest rate 0.25 percentage point at the March 22 meeting, as was widely expected. It also signaled that only one more hike is likely, with a modest chance of two more hikes and little chance of any rate cuts this year. The 12-month Treasury yield dropped to 4.4 percent after the FOMC announcement, suggesting that investors expect the Fed to cut rates below the current range of 4.75 to 5.00 percent fairly soon. Investors seem to believe that the current troubles of the banking sector will slow the economy and inflation much more than the Fed expects (or is willing to admit) and that the Fed will end up reversing its rate hikes this year. Only time will tell who is right.
The March FOMC projections are very close to what FOMC participants projected in December 2022. Since then, two significant but offsetting developments have occurred. First, inflation has been a bit higher and job growth somewhat stronger than projected in December. Second, the failures of Silicon Valley Bank and Signature Bank exposed weaknesses in the balance sheets of some banks that are likely to cause many banks to tighten their lending standards, which will cool the economy off faster than otherwise.
The Fed essentially "split the difference," implicitly deciding that the two factors cancel each other out, leaving the paths for the economy, inflation, and interest rates nearly the same as in December. Market participants obviously believe the tightening of credit conditions in the banking sector will outweigh the stronger momentum of employment and inflation.
Through its role as a bank supervisor, the Fed is in a better position to gauge the economic impact of banking sector troubles than private investors are. But the Fed's weak response to risky behavior at Silicon Valley Bank may call into question its judgment. Investors are betting that the Fed is downplaying the economic impact of banking stresses. However, both investors and the Fed are giving little weight to the possibility that the economy may continue to surprise on the upside.
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