The Fed is likely to hike rates by a quarter point, but it also needs to reassure markets about the banking system

• The US Federal Reserve is expected to hike interest rates by a quarter point on Wednesday amid concerns over stress in the banking system.
• The central bank is also expected to release forecasts on the economy and the path of rate hikes, although some economists say the uncertainty could make those forecasts difficult to come by.
• Investors also await assurances from the Fed that problems with regional banks will be contained.

Federal Reserve Chairman Jerome Powell addresses reporters after the Fed raised its target interest rate by a quarter of a percentage point during a news conference at the Federal Reserve Building in Washington February 1, 2023.

Jonathan Ernest | Reuters

The Federal Reserve is expected to hike interest rates by a quarter point on Wednesday, but it also faces the difficult task of reassuring markets it can handle a worse banking crisis.

Economists largely expect the Fed to raise its Fed Funds target range to 4.75% to 5% on Wednesday afternoon, although some expect the central bank could pause its rate hike amid concerns about the banking system. Futures markets as of Tuesday morning are pricing in about an 80% chance of a rate hike.

The central bank is considering using its interest rate tools while trying to calm markets and stem further bank runs. There are fears that rising interest rates could put further pressure on banking institutions and further restrict lending, hurting small businesses and other borrowers.

“The broader macro data shows that further tightening is warranted,” said Michael Gapen, chief US economist at Bank of America. He said the Fed will have to explain its double-barreled policy. “You must show you can walk and chew gum at the same time, and use your power as lender of last resort to allay any fears of deposit flights at mid-tier banks.”

Federal regulators stepped in to guarantee deposits at the failed Silicon Valley Bank and Signature Bank, and gave banks cheaper loans for periods of up to a year. The Fed joined other global central banks on Sunday to improve liquidity through the perpetual dollar swap scheme after UBS agreed to buy embattled Credit Suisse.

Investors will look to Fed Chair Jerome Powell for reassurances that the central bank can contain banking problems.

“We want to know that this is really about a few idiosyncratic institutions and not a more pervasive problem related to the regional banking model,” Gapen said. “In those moments, the market needs to know that you feel you understand the issue and that you are willing and able to do something about it. … I think they’re exceptionally good at understanding where the pressures are that are driving it and how responses.”

Markets were rocked last month by first a hawkish-sounding Fed and then fears of contagion in the banking system.

Fed officials begin their two-day meeting on Tuesday. The event comes just two weeks after Powell warned a congressional committee that the Fed may have to hike rates even more than expected as it fights inflation.

Those comments sent interest rates skyrocketing. A few days later, the sudden collapse of the Silicon Valley bank stunned markets and sent bond yields down dramatically. Bond yields move inversely with price. Expectations for Fed rate hikes have also shifted dramatically: what was expected at a half-point hike two weeks ago is now up for debate at a quarter-point or even zero.

See grafic…

The 2-year Treasury yield is the most sensitive to Fed policy.

Gapen expects Powell to explain that the Fed is fighting inflation by raising interest rates, but then reassuring markets that the central bank can use other tools to maintain financial stability.

“The things that go into the future will be done from meeting to meeting. It’s going to be data dependent,” Gapen said. “We have to see how the economy develops. … We have to see how the financial markets behave, how the economy reacts.”

The Fed is expected to release its rate decision along with its new economic forecasts at 2pm ET on Wednesday. Powell will speak at 2:30 p.m. ET.

The problem is that they can change their forecast until Tuesday, but how does anyone know?

Diane Swunk

Chief Economist at KPMG

Gapen believes the Fed’s forecasts could show it has a higher terminal rate, or end point, for rate hikes than expected in December. He said it could rise to about 5.4% for 2023 from a previous forecast of 5.1%.

Jimmy Chang, chief investment officer at Rockefeller Global Family Office, said he expected the Fed to hike rates by a quarter point to inspire confidence, but then signaled it was done raising rates.

“I wouldn’t be surprised if we saw a rally because historically when the Fed stops climbing and goes into pause mode, the stock market’s initial knee-jerk reaction is a rally,” he said.

He said the Fed is unlikely to say it will pause, but its messages could be interpreted that way.

“Now they at least want to maintain that atmosphere of stability or trust,” Chang said. “I don’t think they’re going to do anything that could possibly shake up the market. … Depends on hers [projections]I think the market will think this is the last hike.”

Diane Swonk, chief economist at KPMG, said she expected the Fed to likely pause its rate hike due to economic uncertainty and the fact that the contraction in bank lending would equate to Fed policy tightening.

She also doesn’t expect guidance on future rate hikes for the time being, and Powell could stress that the Fed is monitoring developments and economic data.

“I don’t think he can commit himself. I think he needs to keep all the options on the table and say we will do whatever is necessary to promote price stability and financial stability,” Swonk said. “We have sticky inflation. There are signs that the economy is weakening.”

She also reckons the Fed will find it difficult to release its quarterly economic forecasts because the banks’ woes have created so much uncertainty. As it did during the March 2020 pandemic, the Fed could temporarily suspend forecasts, Swonk said.

“I think it’s important to consider that this is shifting the prognosis in some unknown way. You shouldn’t overpromise one way or another,” she said. Swonk also expects the Fed to withhold its so-called “dot plot,” the chart on which it shows anonymous forecasts from Fed officials about the path of interest rates.

“The problem is they can change their forecast until Tuesday, but how does anyone know? They want the Fed to look unified. They don’t want a contradiction,” Swonk said. “These scatter plots could literally change from day to day. Two weeks ago we had a Fed chair willing to go 50 basis points.”

The tightening of financial conditions alone could have the effect of a 1.5 percentage point rate hike by the Fed, and that could lead to the central bank cutting rates later this year, depending on the economy, Swonk said. The futures market is currently forecasting much more aggressive rate cuts than economists, by a full percentage point — or four quarter points — for this year alone.

“If they’re going up and saying they’re going to pause, the market might actually be okay with that. If they don’t do anything, the market might get nervous that the Fed is pulling back its inflation fight after two weeks of uncertainty,” said Peter Boockvar, chief investment officer at Bleakley Financial Group. “In any case, we still have a bumpy road ahead of us.”

The Fed could also make a surprise move by stopping the offflow of securities from its balance sheet. When government bonds and mortgages mature, the Fed no longer replaces them as it did during and after the pandemic to provide liquidity to financial markets. Gapen said a change in balance sheet outflow was unexpected. About $160 billion flowed from the balance sheet in January and February, he said.

But the balance sheet has recently increased again.

“The balance sheet is up about $300 billion, but I think the good news is that most of that went to already known institutions,” he said.