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Top of Mind with SIFMA Insights: Can the Fed Have Its Cake and Eat It, Too?

A Conversation with Katie Kolchin and Dr. Lindsey Piegza

Top of Mind with SIFMA Insights is a new series within the SIFMA Podcast. We’ll be talking with experts from across the industry about key issues impacting the capital markets and financial industry. In the first episode of Top of Mind with SIFMA Insights, SIFMA’s Head of Research, Katie Kolchin, CFA, is joined by Dr. Lindsey Piegza, Chief Economist at Stifel and Chair of the SIFMA Economist Roundtable to discuss the Fed’s fight to simultaneously manage stubborn inflation and turmoil in the banking system.

Transcript

Edited for clarity

Katie Kolchin: Hello and welcome to Top of Mind with SIFMA Insights. I am Katie Kolchin, SIFMA’s Head of Research. This is a new series within the SIFMA podcast where we’ll be talking with experts from across the industry about key issues impacting the capital markets and financial industry. For our first episode, I’m very excited to be joined by Dr. Lindsay Piegza, Chief Economist at Stifel and Chair of the SIFMA Economist Roundtable. Thank you for joining us, Lindsay.

Dr. Lindsey Piegza: Thank you for having me, Katie.

Katie Kolchin: Last week on Wednesday, March 22nd, the Fed raised rates 25 basis points, bringing the Fed funds rate range to 4.75 to 5.0. While this came as little surprise to markets, I think it is safe to say it was quite a shift from what was expected a few weeks prior to the meeting. Markets had been expecting a 50-basis point move after signs that the labor market remains hot and January PCE data increased 0.1% from December levels. not the direction the Fed wants to see. Then came the regional bank turmoil, viewed by many as a sign that monetary policy has worked its way into the economy. This led markets to revise down expectations and the FOMC vote to hike 25 basis points instead of 50. As markets continue to analyze the potential impacts of the banking turmoil on the economy, questions linger as to the Fed’s next move. This situation has unfolded quickly and we were debating whether the economy was in for a hard or soft landing. How did we get here?

Dr. Lindsey Piegza: Well, you’re right. The Fed faced an incredibly difficult decision or conundrum, if you will, in March, and continues to face a growing challenge looking out to the next May decision. Initially, the Fed was walking a very delicate line between taming inflation while attempting to navigate a soft landing. Now the Fed has an added challenge of navigating the tantrums or the wild swings of an incredibly delicate banking system, based on perpetually low rates and accommodative policy. But ultimately, as you mentioned, the Fed opted to strike somewhat of a compromise between a more aggressive 50 basis point increase supported by strong inflation data and a pause in rates amid recent uncertainty in the banking sector. So again, the Fed increased the key lending rate, opted to increase the key lending rate by quote, only 25 basis points, but still now, ninth consecutive increase, marking that near 500 basis point increase since March of last year.

Katie Kolchin: Interesting. Okay, let’s dive into the last FOMC meeting. Was the 25-basis point hike what you were expecting and do you view that as the right move? Please share with us your thoughts on the Fed’s analysis behind this move.

Dr. Lindsey Piegza: Well, first off, yes, it was what we were expecting. But that being said, there certainly was an argument for the committee to avoid not only ramping up the size of rate hikes, but also potentially pausing altogether. After all, As many talking heads have stated, where there is one cockroach, there are often many more. So as such, other banks, financial institutions, holders of longer-dated treasury securities could face similar issues or hardship suggesting then a pause in additional tightening would presumably offer a welcome reprieve for banks and allow the Fed to assess more closely the turmoil that some argue was a direct result of earlier monetary policy decisions, meaning raising rates at the fastest pace in four decades. But on the other hand, a lack of action by the Fed at the March meeting might have itself served to exacerbate market uncertainty with participants already pricing in that 25 basis point hike with a solid probability.

Additionally, I would say that deviating from the earlier suggested policy decision less than a week away from the March FOMC rate announcement could have sent a signal of unnecessary concern after all if the market is safe and sound with the crisis averted and minimal risk of contagion as officials profess and inflation then still remains a sizable threat the Fed continue to hike as they earlier indicated, unless the committee was more concerned about financial markets than they were willing to admit. So, was this the right move, as you say? Well, there is arguably no right answer, or at least no perfect answer that the central bank can provide to the current economic situation. Either pathway is going to be messy and likely result in a downturn, if not an outright recession for everyone. At this juncture then, trying to avoid the greater evil while ensuring a return to a longer run pathway of stronger growth and stable prices. Fed officials, Chair Powell himself, never said it was going to be easy and if history is any indication the last 100 basis points is always the most difficult and the most painful, but the Fed has a job to do. Without price stability, the economy does not work for anyone.

Katie Kolchin: It’s interesting you bring up price stability. There was a recent article in The Economist, and it noted that the Fed has regulatory and lending powers to address financial matters while it has monetary policy, i.e., raising interest rates, for economic goals such as price stability. The tension between stabilizing the financial system, they said, which calls for support from the central bank and rating in price pressures, which calls for tight policy, is extreme. Do you think the Fed can accomplish both with the tools at its disposal?

Dr. Lindsey Piegza: Absolutely. As we’ve already started to hear, that messaging is coming from Fed officials. Most notably, we’ve heard that from St. Louis Federal Reserve Bank President James Bullard, who on Friday said that both financial stability issues can be tackled through additional steps to ease bank strains, while monetary policy targeting high inflation. In fact, if we look at the Fed’s new liquidity facility, for example, this offers a greater ability for the central bank to continue to raise rates by helping to remove or at least offset some of that added pressure on institutions as a result of higher rate policy and the committee also has the option to offer additional liquidity incentives or initiatives as needed, such as dollar swap lines or other measures, as the committee continues to move terminal rate. This essentially allows the Fed to reinstate stability and confidence in the banking sector while remaining focused on its longer-term goal of price stability. So, in other words, perhaps yes, perhaps there is a way the Fed can have its cake and eat it too, but this will very much depend on the depth and duration of the market’s reliance on these alternative lending or liquidity facilities. After all, keep in mind that an increase in liquidity is likely to accelerate or fuel the very inflationary pressures that the Fed is seeking to tap down.

Katie Kolchin: You mentioned the magic phrase in there, terminal rate. So, prior to the banking turmoil, you had been on a news program commenting that the Fed funds rate could go to 6%. Now we have a banking situation where some, if not most, institutions are tightening lending standards on both the commercial and consumer sides. I’ve seen some estimates that the impending credit tightening could be worth around 100 basis points of Fed rate hikes. That said, we are still fighting the inflation battle at plus 5.4% in January, a long way from the Fed’s 2% target. How has the banking landscape changed your estimate for both level and timing of the terminal rate and are you expecting a pause from the Fed? If so, when? And of course, we cannot leave without asking, are you looking for a rate cut in 2023?

Dr. Lindsey Piegza:  Well, you’re right. Despite already nine rounds of tightening, inflation, while off earlier highs, remains stubbornly elevated at more than double the central bank’s target range, or more, depending on one’s preferred measure of prices. While the Fed doesn’t necessarily need inflation to reach 2% before backing off, with the pace of disinflation slowing, meaning the pace of that second derivative improvement slowing, the data have yet to convince Fed officials that inflation is on a meaningful and sustainable downward trajectory. So, if price stability remains the Fed’s primary goal, even with temporary distortions, volatility, or additional pain, then the central bank likely still has work to do beyond the March meeting. In fact, the Fed has reiterated numerous times that the risk of undershooting the needed level of rates to tame inflation is sufficiently with a series of rate reductions. Of course, as more institutions fear a similar fate of SVB, and perhaps even recognize their own shortcomings in risk management or elsewhere, whether self-imposed or the result of, should we say, reinvigorated regulators, tighter lending standards are likely to emerge. And if realized, these higher standards could act to aid the Fed in reaching its goals of tamping down investment, tapping down consumption, and eventually resulting in a slower growth rate and more benign inflation. In other words, the very fear generated by the turmoil as a result of the threat of the Fed continuing to raise rates could itself result in tighter lending limitations and help to do some of the Fed’s work, reducing then the peak level of rates needed to rein in inflation and the level of distress As the March statement read, recent developments are likely to result in tighter credit conditions for households and businesses, and will likely weigh on economic activity, hiring, and inflation.

The extent of these effects, however, is very uncertain, and the committee remains highly attentive to inflation risks. So, in other words, when we look at the statement, the shift in the statement that we saw last may be appropriate, does somewhat softer language of additional policy firming may be appropriate, does not reflect or insinuate a lessened focus on inflation. After all, as we heard from the chairman during the press conference, inflation remains significantly too high, and we will do whatever it takes to reinstate price stability, the chairman said. So, rather, the adjustment in language reflects, I think, the uncertainty in which a change in market conditions will have on taming inflation. Should the recent market events have a minimal or modest impact on conditions and inflation, the pathway for rates will likely look more aggressive. But if recent action results in significantly tighter credit conditions, that would mean monetary policy has less work to do. So, I think what’s very clear is that the Fed will need policy to firm to roughly 6% as we earlier predicted, as you pointed out. However, if tighter credit conditions do 50 basis points or 75 basis points of the Fed’s work in terms of taming inflation, then the peak level of rates may need to be more than only to be five and a quarter percent or just one more rate hike. So, the total firming will be a combination going forward of further rate hikes and more organic adjustment in conditions. In fact, since quote rate hikes pause and in fact since quote rate cuts are not in our best case scenario for 2023 as per the consensus among officials does seem increasingly optimistic that at least one additional rate increase, coupled with a significant firming of market conditions, could be sufficient in taming inflation. But again, we will have to wait to see that realized improvement in price pressures, without which the Fed will continue to hike and hold rates at a higher level for a much longer period than the market anticipates.

Katie Kolchin: Okay, let’s close out discussing our inflation fight. If you think about the three legs of inflation, supply, demand, and labor, you have remained cautious on the labor piece. Could you please share your thoughts on the labor market, how and when you expect to see substantial and sustainable signs of cooling? And do you have a level of unemployment in mind that we will need to hit to register with the Fed? And how has your analysis changed in light of the banking turmoil?

Dr. Lindsey Piegza: Well, it’s an interesting question because the Fed has been clear that a period of pain is not only likely but necessary in the pursuit of price stability. But how much pain can the U.S. economy withstand, the U.S. labor market withstand? How much pain can the U.S. banking system withstand? And has either the economy or the banking sector in a broad sense really experienced any pain as of yet? Listening to the Fed Chairman last week it isn’t clear that the Committee sees any substantial pain on either front. In fact, according to the latest projections, the committee continues to anticipate modest positive growth with a perpetually low unemployment rate and, in fact, a bit more inflation expected over the next 12 months, and of course, the committee’s assessment remains very fluid and is constantly evolving to the incoming data. But I would say at the status quo, it does arguably accurately reflect conditions in the economy.

The U.S. consumer showed surprising resilience at the start of the year, and the labor market, in particular, is still very positive, very solid, to use the Fed’s words. The U.S. labor market continues to add roughly 335,000 jobs on average each month, and with an unemployment rate already at a five-decade low, 11 million job vacancies, meaning job openings, and millions fewer Americans seeking employment, wage pressures remain elevated firmly fixed within a bound of roughly 4.5 to 6 percent as they have for the better part of the past two years. So, from this vantage point, the Fed should feel emboldened to continue to hike rates, as households and businesses have shown only a minimal reaction to nearly 500 basis points in tightening. Or maybe said another way, households and businesses can clearly withstand a further backup in rates, given the still solid nature of the economy. The Fed is intentionally trying to slow the economy. By raising rates, they’re attempting to slow investment and hiring, and as a result produce a slower rate of growth and more benign inflation. But we haven’t seen the meaningful level of job destruction needed to satisfy the Fed that wage pressures will retreat on a sustainable basis. Still well below what the Fed considers the full employment range, unemployment will likely need to rise nearer 6 percent, if not higher. And while the recent turmoil hasn’t necessarily changed my assessment of conditions per se, as we talked about, the impact of tighter lending conditions remains a significant wildcard, potentially compounding the impact of higher rates on hiring, which would work to potentially offer a welcome slowdown to the wage price spiral and by extension then lessening the work or the action needed by monetary policy officials.

Katie Kolchin: With that, I think we can stop here and look forward to the Fed’s next meeting in May. Thank you, Lindsay, for your insights.

Dr. Lindsey Piegza: Thank you very much for having me.

Katie Kolchin: As a reminder to listeners, prior to the June and December FOMC meetings, SIFMA research publishes our economic survey, which includes forecasts from the SIFMA Economist Roundtable on GDP, unemployment, inflation, interest rates, and more. We also review expectations for policy moves at the upcoming FOMC meeting economic topics and how these factors impact monetary policy. Please stay tuned for the June survey. To read our Economist Roundtable survey reports and other SIFMA research reports, please enter SIFMA research into your web browser.

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Katie Kolchin, CFA is Managing Director, Head of Research for SIFMA and the author of SIFMA Insights.

Dr. Lindsey Piegza is the Chief Economist for Stifel Financial and Chair of the SIFMA Economist Roundtable.

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