Given the fresh angst in regional banks and a 7% decline in the KRE regional bank ETF on Tuesday, the market is no longer certain about a Federal Reserve rate hike on Wednesday. The implied odds have fallen to 86% but that would still be a major surprise and holding rates might be seen as a sign of non-confidence in banks; a warning that the Fed knows something the market does.
So by holding, there is a risk the Fed would worsen the current rout on the banks and that's one reason I think they will follow through with 25 basis points.
The real question for the Fed is what to signal next. A hawkish hike is entirely off the table given the backdrop and a fall in job openings on Monday highlighted the progress the FOMC wants to see on a cooling economy. We're also approaching the terminal top in rates so some change in tone is warranted.
The question boils down to how strongly the Fed wants to signal a pause from here?
I think there's a compelling case to pause given the banking rout and I don't think it needs to be explicit for the market to get the message.
"Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain," the FOMC statement said.
Powell hinted at a high level of uncertainty on how much banking crisis might restrain lending but some Fed officials have pegged the baseline at 25 bps. I think the latest round of trouble adds upside to that number and also tells the Fed that if it pushes much further, we could have a larger problem that's much harder to contain and would necessitate a rapid series of rate cuts. In addition, the Fed should start to see the pain in commercial real estate as another avenue for looming tightening.
The current statement says:
"The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time."
Wall Street Journal Fedwatcher Nick Timiraos today writes about potential tweaks to guidance, outlining the 2004-2006 cycle or hikes to 5.25% from 1.00%.
As the Fed was nearing the end of the cycle, it dropped a line that said "some further policy firming may yet be needed" (which is close to what's there now) and replaced it with this in June 2006:
Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.
Ultimately, that was the final rate move of the cycle and after a year-long pause at 5.25%, the financial crisis led to a series of (too slow) cuts to 0%.
At the moment, the Fed may fear damage to its inflation-fighting credibility by explicit highlighting a pause but could go back to the 2006 playbook with the removal of 'additional policy firming' with highlighting that inflation risks remain and that the Fed is data dependent.
A further dovish move would be if Powell doesn't push back hard against market pricing that shows cuts late in the year. He might do this simply by highlighting uncertainty and he could further offer dovish hints by noting that US inflation should fall below 4%, or even 3.5% by mid-year.
