FOMC preview: a dovish hike to provide optionality
Markets expect the FOMC to deliver a 25 basis point interest rate hike.
In a week of relative normality, a live FOMC meeting is usually one of the highlights on the calendar. However, in a week that has already seen the demise of a systematically important European bank and another regional American bank brought to its knees, this week’s FOMC meeting is about as big as it gets.
Past banking crises have shown that bank failures are deflationary as banks face higher funding costs, tighter regulation and lending standards that restrict the flow of credit and slow economic growth.
What is expected?
In recognition of this, the rates market has entirely removed its expectations for a 50bp rate hike that it priced in following Fed Chair Powell’s hawkish testimony to Congress. Instead, it is now 74% priced for a 25bp rate hike on Thursday which would take the Feds Fund rate into a range of 4.75%-5%. After that, 100bp of rate cuts are expected in early 2024.
Target rate probabilities for March 2023 FOMC meeting
For the better part of 12 months, many central banks have been behind the curve, playing catch up to expectations of higher rates priced into rate markets.
The worm has now turned, and after the past week's events, the Fed finds itself in a position where it is expected to deliver one more rate hike before cutting rates.
In summary, because of the banking crisis, the “market” now views the Fed’s main priority as providing liquidity and easier policy to backstop the financial sector and the economy ahead of its fight against inflation.
As a side note, inflation is expected to fall because of bank stress and as credit conditions tighten.
How does the Fed frame this?
The Fed will likely signal that recent events have created uncertainty around the outlook. While a further rate increase may be needed, the Fed is watching closely and prepared to provide easier monetary policy if conditions deteriorate.
Reflecting this, the Feds median Dots will likely be left unchanged at 5.125%. Overall, a dovish hike is expected to allow the Fed the optionality to change course if warranted in the months ahead.
2023 meeting probability dot chart
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