Fed March Update: Rate Rise Persists Amid Mounting Risks

This article outlines the facts surrounding the latest move, the initial market reaction, and its implications for the longer-term investment environment.

The decision and its rationale

The decision to raise rates from the previous target range of 4.5-4.75% to 4.75-5.00% was summarized by Fed Chairman Jerome Powell in his public statement reaffirming the determination to stem inflation: “Inflation remains too high and the labor market remains very tight.”^[1]

The Consumer Price Index (CPI) released on March 14 by the Bureau of Labor Statistics, showed that declining food and shelter costs reduced inflation from 0.5% in January to 0.4% in February (6.4% to 6% annualized).^[2] However, the headline rate is still more than three times the target rate of 2%.

The latest March 10 data gave a mixed picture of employment and the economy. Payroll growth continued to be robust (+311,000 new jobs in February) led by leisure and hospitality while wage growth slowed from 0.3% in January to 0.2% and the average workweek declined to 34.5 hours, implying that new jobs are not all full-time.^[3]

The economic projections were unchanged from the December forecast. Chairman Powell emphasized that although “some additional policy firming may be appropriate”, the important words to focus on are ’may’ and ‘some.’” Notably absent was the word “ongoing,” in the context of future interest rate hikes.

Banking sector turmoil

The Fed had typically based its rate decisions on macroeconomic factors, such as inflation and labor markets. But recent developments in the banking sector have added new factors into consideration.

Briefly, there was a run on several financial institutions, including Silicon Valley Bank (SVB) and Signature Bank in the US, and the Swiss banking giant Credit Suisse, as depositors panicked. While the fall of Credit Suisse resulted from long-standing issues with the bank’s management and years of reputational decline owing to scandals, the case of SVB was due at least partly to the interest rate hikes of the past year.[1]

The Fed has been balancing the two goals of stemming inflation and avoiding recession. The Great Financial Crisis (2007-2008) highlighted the importance of broader financial stability in achieving these two goals. This means the Fed must consider the impact of rate changes on the banking system. It has accordingly initiated an emergency lending program in coordination with other central banks to ensure US dollar liquidity.^[2]

At an earlier Senate hearing on March 7, Fed Chairman Jerome Powell had hinted that interest rates could rise higher than previously anticipated, implying the possibility of a 0.5% rate hike.^[3] The 0.25% increase, therefore, represents a retraction of sorts.

How markets reacted

The decision of the Fed was in line with market expectations on the eve of the announcement.

Stocks rallied initially, but ended the day lower, with the three major indices (Dow Jones, S&P 500, and Nasdaq Composite) down by 1.6% or more. Bank stocks were particularly affected, following comments by Treasury Secretary Janet Yellen that the government was not planning to offer “blanket insurance” for all bank deposits in case of a general contagion.^[1]

Short- and long-term Treasury yields also slipped amid more subdued rate hike expectations.^[2] The US dollar index also fell in line with lower-than-predicted domestic rate expectations.

CME FedWatch, a gauge of market expectations of interest rate movements, showed differing views in 2023, but the consensus was towards a 0.50% decline by year-end,^[3] despite Powell’s indication that rate cuts are unlikely this year.

What this means for investors?

Aside from short-term market movements, the important consideration for investors is the outlook for the US economy which will inform the performance of specific asset classes and sectors.

US government measures may help avert a run on vulnerable regional banks with substantial unrealized losses.^[1] But more conservative lending policies in an uncertain environment may well impact consumer spending and business activity.

This may have the same effect of several rate increases even if the Fed stops further rate increases.^[2]

Answering questions following the announcement, Chairman Powell stated that ‘the pathway still exists’ to the hoped-for soft landing, and the Fed is certainly “trying to find it.” He also observed that economic reactions are non-linear and hard to model in a straightforward manner.

The correct approach is therefore one of caution, not complacency. There is a long way to go before the US economic challenges subside.

^[1] Federal Reserve

^[2] Bureau of Labor Statistics

^[3] Bureau of Labor Statistics

[4] Reuters

^[5] Federal Reserve

^[6] Federal Reserve

^[7] CNBC

^[8] Reuters

^[9] CME FedWatch

^[10] Economist

^[11] New York Times