With the banking crisis on hold, the Fed is back to fighting inflation

Published Thu, Apr 20 202310:32 AM EDT

The Federal Reserve's policy pendulum has swung back to inflation fighting. Following a tense few weeks of having to stave off a potentially crippling financial crisis, policymakers have turned their attention back to battling stubborn inflation that threatens to send the economy into recession later this year. With the banking problems seemingly at bay for now, Fed officials have made it clear in recent remarks that tight monetary policy is likely to be around for a while, and a pivot is unlikely. That means a near-certainty of another rate hike in two weeks, and a diminishing likelihood of any cuts, at least in 2023. "We have not changed our call for the Fed to continue to raise rates through July to a terminal 5.5-5.75%," Citigroup economist Andrew Hollenhorst said in a note Wednesday, referring to the peak rate. "The view is based on banking sector stress remaining contained, the economic expansion continuing and core inflation remaining stubbornly high." Citi's call is one of the most hawkish on Wall Street, implying another 75 basis points of rate increases on top of the 4.75 percentage points in hikes since March 2022. By contrast, traders on Wednesday afternoon were pricing in a nearly 90% chance of a 25 basis point increase in May, before a pause and then at least 50 basis points worth of cuts before the end of 2023, according to CME Group estimates . A basis point is 0.01 percentage point. The fed funds rate is currently targeted in a range between 4.75%-5%. "So long as the data flow does not contradict these views, and it has not in recent weeks, we expect markets to slowly price back in the hikes that were priced-out in March," Hollenhorst wrote. A cooling crisis Indeed, Fed Chairman Jerome Powell and other central bankers in late February and early March were indicating chances of half-point rate hikes . But that was before Silicon Valley Bank (SVB) in Santa Clara, California and Signature Bank in New York were shuttered in the wake of a deposit run that called into question the Fed's rate-hiking strategy. The banks were hit with duration risk when they had to sell longer-maturity bonds that had lost value due to higher rates. However, emergency lending vehicles the Fed put into place seem to have stemmed the fear of bank liquidity, at least for now. For one thing, there's been only limited use of emergency lending facilities the central bank implemented. For another, gauges such as the St. Louis Fed's Financial Stress Index and the Chicago Fed's National Financial Conditions index are both indicating that there is considerably less economic pressure since the spike following the March 12 failure of SVB. Inflation indicators, meanwhile, remain high even though some have abated. Core inflation as measured by the Fed's preferred personal consumption expenditures price index was 4.6% in February, and a full point higher than that as measured by the consumer price index for March . Both are well above the central bank's 2% goal. "I interpret these data as indicating that we haven't made much progress on our inflation goal, which leaves me at about the same place on the economic outlook that I was at the last FOMC meeting, and on the same path for monetary policy," Fed Governor Christopher Waller said in an April 14 speech . Atlanta Fed President Raphael Bostic likewise told CNBC on Tuesday that he anticipates one last quarter-point hike in May but doesn't expect cuts this year. St. Louis Fed President James Bullard told Reuters earlier this week that he also thinks the funds rate should go to around 5.5%, making him among the most hawkish members of the Federal Open Market Committee, where both he and Bostic are nonvoters this year. Watching the banks, and the market To be sure, the banking situation remains in flux and could yet shape Fed policy. Chicago Fed President Austan Goolsbee has estimated that tougher credit conditions could be the equivalent of 25-75 basis points worth of official tightening. At the same time, the Fed is continuing to reduce its bond holdings by as much as $95 billion a month. In fact, by the San Francisco Fed's estimate , rate hikes and quantitative tightening have pushed the fed funds rate up to the equivalent of 6.27%, or about 1.5 percentage points higher than the nominal rate. "At moments like this, of financial stress, the right monetary approach calls for prudence and patience — for assessing the potential impact of financial stress on the real economy," Goolsbee said on April 11. "If the response to recent banking problems leads to financial tightening, monetary policy has to do less." Still, a cut under the current conditions seems unlikely. The Fed rarely cuts when market volatility is this tame, said Nicholas Colas, co-founder of DataTrek Research. "The Federal Reserve tends to cut interest rates only when stock market volatility rises quickly due to either a geopolitical shock and/or a clearly imminent recession. As far as we're concerned, this is the real 'Fed put," Colas wrote in a note this week. The CBOE Volatility Index , a popular gauge of market fear, sat at nearly 17 on Thursday morning, well below its long-term closing average of 19.7. At the same time, the two-year Treasury note yield, which is most sensitive to Fed policy moves, has jumped about half a percentage point over the past two weeks. "Between now and those expected rate cuts later this year we will, therefore, need to see the sort of volatility that pushes the Fed to act," Colas wrote. "Otherwise, why would the Fed do anything other than keep rates where they are?"