Predicting the Fed, Market Volatility and Banking Sector Stress
The US Federal Reserve Bank Federal Open Market Committee will announce its monetary policy decision tomorrow at 7 pm CET.
The decision on what to do with monetary policy has become tremendously more challenging and significant, given the stress and questions that have surfaced about the health of the US banking system.
However, the Fed needs to remain focused on fighting and getting inflation under control. Therefore, our base case calls for the Fed to hike rates by 25bp, highlighting its dual mandate of maximum employment and price stability, but stress more on price stability (Price stability means that inflation remains low and stable over the longer run.). But that’s not all.
Indeed, the Fed and the Treasury are also concerned about financial market volatility, especially bond market volatility. Elevated market volatility for an extended period can be a significant destabilizing, destructive force with negative spillovers across the banking system, markets, and investor confidence.
The problem with predicting the Fed is getting the balance right between what the Fed should do and what the Fed will do.
Beyond the policy rate question, the Fed must use this opportunity to restore confidence in the US banking system. Chair Powell should highlight that the Fed, FDIC, and Treasury are working together and will address any issues that could trigger a crisis of confidence in the US banking system.
Here is what the Fed, the FDIC, and the Treasury should do tomorrow, preferably simultaneously:
- Monetary Policy – The Fed should hike rates by 25bp, stress the need to continue the inflation fight and emphasize the need for complete confidence in US markets and the banking sector. Given the banking and market backdrop, we had previously priced in a 50bp hike but have moved our rate hike expectations to 25bp.
- US Banking System – The FDIC and Treasury should announce more robust deposit insurance measures to help calm depositors, investors, and markets. However, underwriting all deposits should be conditional, subject to banks meeting a list of criteria to ensure banks manage their business well and adequately. Meanwhile, these institutions should find a new accounting methodology for the mark-to-market of securities held by banks.
- Global Coordination – Fed and Treasury should again bring to everyone’s attention the coordinated central bank action to enhance the provision of USD liquidity announced on March 19.
US agencies and the central bank may remain in “firefighting” mode indefinitely unless there is a well-coordinated response from Fed, FDIC, and the Treasury. An inadequate response would not be welcomed and would likely result in a further loss of confidence in the US’s ability to manage its economy in an increasingly complex macro backdrop.
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