A pregnant pause: Fed walks fine line
The Fed remains flexible and ready to act.
The Federal Open Market Committee (FOMC), the policy setting arm of the Federal Reserve, is scheduled to meet on March 21-22. Data on employment and inflation for January and February are worrisome in that they revealed an acceleration in hiring, demand and underlying inflation. Lower prices at the gas pump helped cool inflation relative to a year ago but savings were redeployed to support spending elsewhere in the economy. That shift suggests that inflation is getting sticky.
The shift did not go unnoticed at the Fed. Chairman Jay Powell put a half percent hike and a higher peak in rates on the table during his testimony to Congress on March 7 and 8. That was prior to a series of inflation and retail sales reports that reinforced that stance during the week of March 13.
It is worth noting that the data are much more susceptible to revision and harder to capture upon their initial release than we saw in the past. Response rates have been falling for years; the pandemic accelerated those trends. Revisions are larger and can completely reshape economic narratives. The Fed is aware of those problems.
Two weeks are an eternity in the post-pandemic economy. At the same time that Main Street appeared to be heating up, Wall Street woke up to the potential for higher rates for longer by the Fed. The abrupt tightening of credit conditions that followed revealed fragilities that were building in credit markets.
Now, credit conditions have tightened across a large swath of the economy, even as market interest rates have fallen. That tightening of credit market conditions is expected to hit the backbone of recent labor market gains, businesses with fewer than 250 workers, the hardest.
Nearly four of every five job openings, which was still hovering at a ratio of 1.9 per job seeker in January, were among firms with fewer than 250 employees. This is at the same time that smaller, often younger firms, were absorbing high-profile layoffs at larger, more established firms.
The resulting shift in credit market conditions could do much of the heavy lifting for the Fed, alleviating the need for additional rate hikes. The risk of a harder landing with higher unemployment has just risen.
That leaves the Fed in a bit of a bind. It is clear that FOMC members could opt out of the half percent hike Chairman Powell put on the table during his Congressional testimony on March 7 and 8. Markets are now pricing in a flip of a coin probability that the Fed raises only a quarter percent or pauses.
The debate on whether to go a quarter or pause is more complicated than many realize. A pause runs the risk of signaling to the public and financial market participants that the financial market fragilities revealed in recent weeks are worse than they appear. That could spook already jittery markets. This is a concern that the European Central Bank (ECB) weighed when it opted to raise rates by a half percent but did not provide guidance on future rate hikes.
That said, the ECB is further behind the curve on rate hikes and stoking a more persistent inflation than many of its counterparts, including the Fed. The ECB did assure that it would use all the tools to promote financial stability, despite the decision to raise rates.
A smaller quarter point hike, with similar promises, is seen by many as the path of least resistance by the Fed. It would underscore the Fed’s commitment to fighting inflation, even as the odds of a deeper recession rise.
Our own read is that the Fed is, at its heart, a risk-hedging institution; it hedges against the worst mistake it could make at any given time. Two weeks ago that error was stopping too soon and stoking a more prolonged and corrosive bout of inflation, or worse. Now, the risk is to stem a more dramatic tightening of credit conditions and preserve financial stability.
A rate hike now might have to be quickly reversed to deal with a deeper, less contained recession and disinflation. Why would the Fed raise rates when it may be forced to cut rates so much sooner than previously hoped?
It is not an easy call. We have long argued that fighting inflation for the Fed is a marathon, not a sprint. Getting through the hardest mile to cross the finish line and derail inflation without adding to financial market instability takes focus. A pause to assess the course and what lies ahead is part of that process.
Hence, our forecast for a pregnant pause by the Fed – stop now with the promise to deliver later on rate hikes if needed. An inter meeting hike or cut in rates is always possible as economic conditions shift.
The Fed is likely to suspend its summary of economic projections (SEP), which are due at the March meeting. Members have until Tuesday to change those submissions but providing guidance on where individual members of the leadership of the Federal Reserve system see rate hikes and the economy going now seems counterproductive; they don’t know and projections could create more chaos than clarity.
There is a precedence for suspending the SEP. The Fed abandoned the SEP at its March 2020 meeting as liquidity in the Treasury bond market seized; uncertainty about the outlook was too high.
Liquidity in the Treasury bond market has never returned to its pre-crisis levels. Last week, it reached the lowest level since March 2020. That is yet another reason for the Fed to pause. Liquidity in the Treasury bond market is the oil of the market machine; without it, the entire economy seizes.
That leaves a pregnant pause with a high level of uncertainty about the course of rates and the economy going forward. The Fed may also decide to change its current balance sheet operations, which had the Fed’s balance sheet shrinking by $90 billion a month. The balance sheet rose over the last week as borrowing at the Fed’s discount window and its new funding facility soared.
The silver lining is that the current situation is not the same as we faced in the fall of 2008. Back then, we were already eight months into a recession and consumer and corporate balance sheets were riddled with debt. The subsequent seizure in credit markets and losses that the subprime crisis precipitated were already being felt. Today, we have a tail wind of employment gains and excess saving in the top 40% of households to help cushion the blow of tighter credit conditions and potential for credit losses.
The moral of the story: Regardless of whether the Fed hikes or pauses, it will be ready to pivot to handle whatever comes next – be it rate cuts or additional hikes. If anything, this Fed has proven it is agile and prepared to shift in a remarkably short period of time.