Economists think Fed will keep raising rates despite bank turmoil

The Federal Reserve will keep raising its benchmark policy rate, holding it above 5.5 per cent for the rest of the year, despite turmoil across the US banking sector, according to a majority of leading academic economists polled by the Financial Times.

The latest survey, conducted in partnership with the Initiative on Global Markets at the University of Chicago’s Booth School of Business, suggests the US central bank still has work to do to stamp out stubbornly high inflation, even as it contends with a crisis among midsize lenders following the implosion of Silicon Valley Bank.

Of the 43 economists surveyed between March 15 and 17 — just days after US regulators announced emergency measures to stem contagion and fortify the financial system — 49 per cent forecast the federal funds rate to peak between 5.5 per cent and 6 per cent this year.

That is up from 18 per cent in the previous survey in December and compares to the rate’s current level of between 4.50 per cent and 4.75 per cent.

Another 16 per cent estimated it would top out at 6 per cent or higher, while roughly a third thought the Fed would stop short of these levels and cap its so-called “terminal rate” below 5.5 per cent. Moreover, nearly 70 per cent of the respondents said they did not expect the Fed to deliver cuts before 2024.

The policy path projected by most of the economists is markedly more aggressive than current expectations reflected in fed funds futures markets, underscoring the uncertainty clouding not only the Fed’s rate decision on Wednesday but also the trajectory over the coming months.

Traders have since last Friday scaled back how much more the Fed will squeeze the economy given concerns about financial stability. They now wager the central bank will only lift its policy rate by another quarter of a percentage point before wrapping up its tightening campaign. That would translate to a terminal rate just below 5 per cent. They also increased bets the central bank would rapidly reverse course and implement cuts this year.

“The Fed is really caught between a rock and a hard place,” said Christiane Baumeister, a professor at the University of Notre Dame. “They have to continue fighting inflation but now they have to do that against the background of elevated stress in the banking sector.” 

Baumeister, who participated in the survey, urged officials against “prematurely” stopping their monetary tightening campaign, however, calling it a “matter of keeping the Fed’s credibility as an inflation fighter”.

Roughly half of the respondents said the events associated with SVB had led them to slash their forecasts for the fed funds rate by the end of 2023 by 0.25 percentage points. About 40 per cent were evenly divided between the rout causing no change or possibly more tightening in the end versus a half-points’ worth of easier policy from the central bank.

A majority thought the actions undertaken by government authorities were “sufficient to prevent further bank runs during the current interest rate tightening cycle”.

Jón Steinsson of the University of California, Berkeley was one of the panellists to conclude the Fed and its regulatory counterparts had successfully contained the turmoil and said it “would be a mistake to alter the tightening cycle appreciably”.

The more hawkish stance stems from a more pessimistic view about the inflation outlook.

Most of the economists surveyed expect the Fed’s preferred gauge — the core personal consumption expenditures price index — to remain at 3.8 per cent by year-end, roughly a percentage point lower than its January level but still well above the central bank’s 2 per cent target. In December, the median core PCE estimate for the end of 2023 stood at 3.5 per cent.

In fact, nearly 40 per cent of the respondents said it was “somewhat” or “very” likely that core PCE would still exceed 3 per cent by the end of 2024. That is roughly double December’s share.

Deborah Lucas, a professor of finance at the Massachusetts Institute of Technology who participated in the survey, said she holds a more benign view about the inflation outlook, but warned the Fed’s tools were largely ineffective to address what she sees as a problem stemming from supply shocks, “aggressive” fiscal policy and elevated savings among Americans.

“What the Fed will do if it raises interest rates too aggressively is it will cut off necessary investment and do very little about inflation,” she said.

One ongoing debate is how significant a credit crunch is under way across the country as the regional banking sector seizes up.

Stephen Cecchetti, an economist at Brandeis University who previously led the monetary and economic department at the Bank for International Settlements, said he expects to see demand on the whole “pull back”.

“Financial conditions are tightening without them doing anything,” he said of the Fed.

A slim majority expect the National Bureau of Economic Research — the official arbiter of when US recessions begin and end — to declare one in 2023, with the bulk holding the view it will occur in the third or fourth quarter. In December, a majority thought it would occur in or before the second quarter.

Still, the recession is forecast to be a shallow one, with the economy still growing 1 per cent across 2023. The unemployment rate, meanwhile, is projected to rise to 4.1 per cent by year-end, up from its current 3.6 per cent level. It will eventually peak between 4.5 per cent and 5.5 per cent, 61 per cent of the economists reckon.