The U.S. Federal Reserve (Fed) delivered another 25-basis-point (bp) rate hike on March 22, bringing cumulative rate increases over the past 12 months to 450 bps.

The Fed’s post-meeting press release directly addressed the recent concerns about the U.S. banking system in the wake of the collapse of Silicon Valley Bank and Signature Bank, noting that “[t]he U.S. banking system is sound and resilient,” and though recent developments are likely to result in stricter lending standards, it is uncertain how much stricter, and what the effects of changing standards will be on the real economy.

Tamping down inflation remains Job One at the U.S. central bank, though the path to that goal likely will involve less rapid rate hikes in the future. The FOMC 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 its 2% target—a change in language forecasting “ongoing increases” in the fed funds rate in the February statement.

Markets initially appeared to take some comfort in the updated, quarterly Summary Economic Projections (SEP) and the press conference after the March meeting, as equity indexes climbed before a late-session retreat, and Treasury yields fell. Some highlights:

– The updated SEP showed median fed funds rate projections at 5.1% (unchanged from the December SEP forecast) at the end of 2023, 4.3% (+0.2%) at the end of 2024, and 3.1% (unchanged) at the end of 2025. The fact that the Fed raised rates by 25 bps on March 22, and that the terminal rate estimate in the SEP was unchanged at 5.1%, implies that policymakers would likely have tightened by 50 bps and raised the terminal estimate at this meeting were it not for the turmoil in the banking system; stronger economic data and disappointing inflation results since early February would have justified a more aggressive approach.

– Seventeen out of 18 FOMC members pegged rates at 5.1% or higher at the end of 2023 and only one expected rates to be below 5.1%. The skew in 2024 and 2025 was also to the upside, though to a lesser degree.

– The unemployment rate was expected to increase to 4.5% (-0.1%) by the end of 2023, tick up to 4.6% at the end of 2024 (unchanged), and remain at 4.6% (+0.1%) at the end of 2025. That is consistent with slowing GDP growth in 2023 and 2024, and on-trend economic growth thereafter. The SEP forecast for GDP is for 0.4% in 2023, 1.2% in 2024, and 1.9% in 2025.

– At his post-meeting press conference, Fed Chair Jerome Powell said “[if] we need to raise rates higher we will … I think for now though, we see the likelihood of credit tightening.” He added that “we’re always prepared to change” the quantitative tightening program if needed, but there’s “no evidence” that’s needed now, he said.

– The banking-sector issues—and the resultant tightening in credit conditions—mentioned in the FOMC communique could result in the equivalent of a rate hike or more, Powell said, “but that cannot be judged at this point.”

– The gap between the “dot plot” forecast of Fed policymakers and the market pricing of Fed policy remains wide, however. Powell said the FOMC still sees no rate cuts that markets are looking for. The Fed’s 2023 forecast of 5.1% suggests that the current tightening cycle is just about over. But in late trading on March 22, fed funds futures indicated that the market sees an implied fed funds rate of 4.12% at year end—a full percentage point below the Fed’s median projection. The market is currently anticipating 75-100 basis points of rate cuts by the end of 2023, and the Fed is forecasting zero rate cuts. That divergence is slightly larger than it was after the Dec. FOMC meeting, but not materially wider, and reflects a disconnect between market expectations on future Fed policy and the Fed’s own statements that have existed for the last several months.

Policy & Investment Implications

The Fed remains vigilant and determined to do whatever it takes to bring inflation back down to 2%. For now, the central bank believes that will likely require one more 25-bp increase in the policy rate, but it could end up doing more increases or cut rates depending on the severity of the impact from tighter bank lending standards.

While the Fed’s March policy decision incorporates recent developments in the banking system, it was very consistent with the Fed’s approach since hiking began—a focus on stopping inflation and an acknowledgment of existing conditions. The Fed is clearly nearing the end of its hiking cycle, although there is still a wide range of views regarding the peak fed funds rate, and how long policymakers will pause before their next actions. Moreover, the uncertainty posed by the potential credit tightening through the banking system makes the Fed’s job all the more difficult, increasing the likelihood of both a sharper downturn than previously thought, and also of more persistently elevated inflation than the market anticipates. As a result, we find the resulting investment implications consistent with our recent views. The potential for persistent inflation still favors a focus on short-duration bond strategies, particularly since the Fed is nearing the end of its hiking campaign. Meanwhile, the resilience in the U.S. economy, aided by a still-robust labor market, allows for prudent credit exposure as well, including through short-duration, high yield strategies.