This is why Fed officials are saying more rate hikes are needed.
A joint meeting of the Federal Open Market Committee and the Board of Governors of the Federal Reserve System was held in the offices of the Board of Governors on Tuesday, May 2, 2023, at 10:00 a.m. and continued on Wednesday, May 3, 2023, at 9:00 a.m
Developments in Financial Markets and Open Market Operations:
The manager turned first to a review of developments in financial markets.
- Asset prices were less volatile and financial market conditions eased somewhat over the intermeeting period as investor sentiment around the banking system stabilized.
- On net, nominal Treasury yields declined, equities appreciated, credit spreads tightened, and the trade-weighted value of the dollar depreciated.
Measures of implied volatility declined across markets.
- Policy-sensitive rates, however, fluctuated a fair amount over the period, particularly in response to economic data but also because of market perceptions of risk and liquidity conditions.
- Treasury market liquidity improved somewhat over the period but remained challenged.
- Treasury cash and futures markets continued to function in an orderly manner despite the lower-than-normal liquidity.
- Regarding developments late in the intermeeting period, the closure and acquisition of First Republic Bank were seen as orderly, though investors remained focused on stresses in the banking sector.
In addition, the U.S. Treasury Department announced it may not be able to fully satisfy the federal government's obligations as early as June 1 if the debt limit is not raised or suspended, but that the actual date this event would occur might come a number of weeks later.
- Yields on Treasury bills and coupon securities maturing in the first half of June increased notably amid significant volatility.
Deposit outflows from small and mid-sized banks largely stopped in late March and April. Although equity prices for regional banks fell further over the period, for the vast majority of banks these declines appeared primarily to reflect expectations for lower profitability rather than solvency concerns.
- Market participants remained alert to the possibility of another intensification of banking stress.
Responses to the Open Market Desk's Survey of Primary Dealers and Survey of Market Participants suggest that investors' macroeconomic outlooks were little changed from March despite ongoing focus on the implications of the expected tightening of credit.
- Respondents saw upside inflation risks, albeit less than in March.
- Market participants broadly expected a 25 basis point rate increase at the May meeting and saw the resulting rate as the likely peak for the current tightening cycle.
- Survey respondents assigned a much higher probability to the peak federal funds rate being between 5 and 5.25 percent than they did in March.
- However, respondents still assigned a substantial probability that the peak rate may turn out to be above 5.25 percent.
- Respondents expected the peak rate to be maintained through the January 2024 FOMC meeting.
Regarding the balance sheet and money markets, balance sheet runoff continued to proceed smoothly and overnight secured and unsecured rates continued to trade well within the target range for the federal funds rate.
- Respondents to the Desk's surveys generally expected that overnight reverse repurchase agreement (ON RRP) balances will remain elevated in the near term before declining later this year.
- The ON RRP facility continued to support effective policy implementation and control over the federal funds rate, providing a strong floor for money market rates.
- Balances at the ON RRP facility remained within their recent range, indicating that use of the facility was not an important factor driving outflows of deposits from the banking system.
- Use of the ON RRP facility declined at times over the intermeeting period in response to increases in rates on overnight secured money market instruments and on short-term Federal Home Loan Bank debt.
The Committee voted unanimously to renew the reciprocal currency arrangements with the Bank of Canada and the Bank of Mexico; these arrangements are associated with the Federal Reserve's participation in the North American Framework Agreement of 1994.
- In addition, the Committee voted unanimously to renew the dollar and foreign currency liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank.
- The votes to renew the Federal Reserve's participation in these standing arrangements occur annually at the April or May FOMC meeting.
By unanimous vote, the Committee ratified the Desk's domestic transactions over the intermeeting period.
- There were no intervention operations in foreign currencies for the System's account during the intermeeting period.
Staff Review of the Economic Situation:
The information available at the time of the May 2–3 meeting indicated that real gross domestic product (GDP) had expanded at a modest pace in the first quarter.
- Labor market conditions remained tight in March, as job gains were robust and the unemployment rate was low. Consumer price inflation—as measured by the 12‑month percent change in the price index for personal consumption expenditures (PCE)—continued to be elevated in March.
- Limited data were available on economic activity during the period after the onset of banking-sector stress in mid-March, although several recent surveys—such as the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) in April, the National Federation of Independent Business's survey in March, and the Federal Reserve Bank of New York's Survey of Consumer Expectations in March—indicated that bank credit conditions were tightening further.
The pace of increases in total nonfarm payroll employment slowed in March but was still robust, and the unemployment rate ticked down to 3.5 percent.
- The unemployment rate for African Americans fell to 5.0 percent, and the jobless rate for Hispanics dropped to 4.6 percent.
- The aggregate measures of both the labor force participation rate and the employment-to-population ratio edged up.
- The private-sector job openings rate—as measured by the Job Openings and Labor Turnover Survey—moved down markedly during February and March but remained high.
Recent measures of nominal wage growth continued to ease from their peaks recorded last year but were still elevated.
- Over the 12 months ending in March, average hourly earnings for all employees rose 4.2 percent, well below its peak of 5.9 percent a year earlier.
- Over the year ending in March, the employment cost index (ECI) for private-sector workers increased 4.8 percent, down from its peak of 5.5 percent over the year ending in June of last year.
- Consumer price inflation remained elevated in March but continued to slow.
Total PCE price inflation was 4.2 percent over the 12 months ending in March, and core PCE price inflation—which excludes changes in consumer energy prices and many consumer food prices—was 4.6 percent; the total inflation measure was down markedly from its level in January, while the core measure was only slightly lower.
- The trimmed mean measure of 12-month PCE price inflation constructed by the Federal Reserve Bank of Dallas was 4.7 percent in March.
- The latest survey-based measures of longer-term inflation expectations from the University of Michigan Surveys of Consumers in April and the Federal Reserve Bank of New York's Survey of Consumer Expectations in March remained within the range of their values reported in recent months; near-term measures of inflation expectations from these surveys moved up but were still below their peaks seen last year.
Real GDP growth was modest in the first quarter, led by an increase in PCE.
- Gains in consumer spending picked up for the quarter as a whole, driven by a surge in January that was followed by a small net decline over February and March.
- Light motor vehicle sales, however, picked up notably in April.
- Growth in business fixed investment slowed further in the first quarter, and new orders for nondefense capital goods excluding aircraft continued to decline in March, pointing to weakness in capital goods shipments in the near term.
- Residential investment declined further in the first quarter but at a slower pace than last year. Net exports made a small positive contribution to GDP growth in the first quarter, as exports rebounded more strongly than imports from their fourth-quarter declines.
- U.S. manufacturing output fell in March, and near-term indicators—such as national and regional indexes for new orders—pointed to more softening in factory output in the coming months.
- Foreign economic activity rebounded in the first quarter, reflecting the reopening of China's economy from its COVID-19-related shutdowns, a pickup in the economies of Canada and Mexico, and the resilience of Europe's economy to the energy price shock from Russia's war on Ukraine; a mild winter also helped reduce energy demand in Europe. In contrast, economic growth elsewhere in emerging Asia was weak in the first quarter mainly due to a pronounced tech-cycle slowdown.
- Oil prices edged down amid concerns about the global economic outlook. A slowing of retail energy inflation continued to contribute to an easing of headline consumer price inflation in many advanced foreign economies (AFEs).
Core inflation showed signs of easing in some foreign economies but remained persistently elevated amid tight labor markets.
- Accordingly, many foreign central banks continued their monetary policy tightening.
- That said, some central banks paused their policy rate increases or altered their forward guidance amid uncertainty about the global economic outlook and the recent banking-sector stress.
- Some also signaled a shift toward a more data-dependent approach in future decisions.
Staff Review of the Financial Situation
Market sentiment improved over the intermeeting period, with concerns about a sharp near-term deceleration in economic activity appearing to recede as stress in the banking sector declined.
- The market-implied path for the federal funds rate in 2023 increased modestly over the period. Broad equity price indexes increased, although equity prices of some regional banks were lower, and equity market volatility declined.
- Financing conditions continued to be restrictive, and borrowing costs remained elevated.
- Over the intermeeting period, the market-implied path for the federal funds rate in 2023 rose modestly, partially unwinding the sharp decline observed in early March due to the banking-sector stress.
- For 2024 and 2025, the implied policy path based on overnight index swaps fluctuated amid mixed economic data releases, and declined slightly on net.
- Yields on nominal Treasury securities with maturities greater than one year moved lower, and inflation compensation at medium- and long-term horizons edged down slightly.
- Measures of uncertainty about the path of interest rates declined modestly but remained substantially elevated by historical standards.
Broad stock price indexes increased moderately, and the VIX—the one-month option-implied volatility on the S&P 500—decreased notably over the intermeeting period.
- However, market participants remained attentive to developments at regional banks. Equity prices at such banks broadly declined over the intermeeting period in part because of higher funding costs, as well as concerns about profitability and a possible deterioration in the performance of commercial real estate (CRE) loans.
- Risk sentiment in foreign financial markets also improved, on net, over the intermeeting period amid reduced investor concerns about the banking sector, leading to moderate increases in broad equity indexes and declines in option-implied measures of equity volatility. That said, equity prices for euro-area banks declined somewhat, on net, and remained significantly lower than their levels before the onset of banking stresses in early March. Market expectations of policy rates and sovereign yields were little changed in most AFEs but rose notably in the U.K., in part because of higher-than-expected wage and inflation data.
The dollar continued its earlier depreciation as differentials between U.S. and AFE sovereign yields narrowed and global risk sentiment improved.
- Outflows from funds dedicated to emerging markets slowed to near zero over the intermeeting period, while sovereign credit spreads for emerging market economies were little changed on net.
- U.S. markets for commercial paper (CP) and negotiable certificates of deposit (NCDs) stabilized over the intermeeting period. Spreads for lower-rated nonfinancial CP, which spiked following Silicon Valley Bank's closure, narrowed significantly. Outstanding levels of CP and NCDs increased modestly over the intermeeting period, while the share of short-maturity unsecured issuance of CP and NCDs fell to normal levels, reflecting a net easing of stress associated with regional banks.
- Conditions in overnight bank funding and repurchase agreement markets remained stable over the intermeeting period, and the increase of 25 basis points in the Federal Reserve's administered rates following the March FOMC meeting fully passed through to overnight money market rates.
The effective federal funds rate printed at 4.83 percent every day during the period, while the Secured Overnight Financing Rate averaged 4.81 percent—slightly above the offering rate at the ON RRP facility.
- Daily take-up in the ON RRP facility remained elevated, reflecting continued significant usage by money market mutual funds, ongoing uncertainty around the policy path, and limited supply of alternative investments such as Treasury bills.
In domestic credit markets, borrowing costs for businesses and households eased modestly in some markets but remained at elevated levels.
- Over the intermeeting period, yields on corporate bonds declined moderately, and yields on agency residential mortgage-backed securities and 30-year conforming residential mortgage rates moved a little lower. However, interest rates on short-term small business loans continued to rise through March and reached their highest levels since the Global Financial Crisis.
Credit flows for businesses and households slowed moderately, as high borrowing costs and market volatility amid stress in the banking sector appeared to weigh on financing volumes in some markets. While issuance of nonfinancial corporate bonds and leveraged loans slowed notably in mid-March amid stress in the banking sector, issuance normalized over the intermeeting period as that stress abated later in the month and broader market sentiment rebounded.
- In April, speculative-grade nonfinancial bond issuance was solid, while investment-grade nonfinancial bond issuance was subdued, in part due to seasonal factors.
- Growth in commercial and industrial (C&I) loans on banks' books was weak in the first quarter of 2023 relative to its pace in 2022.
- In the April SLOOS, banks reported further tightening of standards for most loan categories over the past three months, following widespread tightening in previous quarters. Banks of all sizes expected their lending standards to tighten further for the rest of 2023. The most cited reason for tightening C&I standards and terms was a less favorable or more uncertain economic outlook. Mid-sized banks—those that have total consolidated assets in the range of $50 billion to $250 billion—tightened C&I standards more than other banks and additionally reported that a deterioration in their current or expected liquidity position was an important reason for their tightening. Such banks account for a bit over one-fourth of C&I lending. Banks of all sizes expected to tighten C&I standards further over the remainder of the year, with small and mid-sized banks more widely reporting this expectation.
Although CRE loan growth on banks' balance sheets remained robust in the first quarter, the April SLOOS indicated that loan standards across all CRE loan categories tightened further in the first quarter. The reported tightening in standards over the first quarter was particularly widespread for mid-sized banks. Banks also reported that they expected to tighten CRE standards further over the remainder of the year, with mid-sized banks very broadly reporting this expectation.
- Meanwhile, commercial mortgage-backed securities (CMBS) issuance was very slow in February and March, amid higher spreads and volatility as well as tighter lending standards.
Credit remained broadly available in the residential mortgage market for high-credit-score borrowers who met standard conforming loan criteria, but credit availability for households with lower credit scores remained tight.
- In the April SLOOS, the net percentages of banks reporting tighter standards for all consumer loan categories during the first quarter were elevated relative to their historical range, and respondents expected that standards would continue to tighten over the remainder of 2023.
- Even so, consumer loans grew at a robust pace in the first quarter, with a continued strong expansion in revolving credit balances.
- Overall, the credit quality of most businesses and households remained solid but deteriorated somewhat for businesses with lower credit ratings and for households with lower credit scores. The credit quality of C&I and CRE loans on banks' balance sheets remained sound as of the end of the fourth quarter of last year. However, in the April SLOOS, banks frequently cited concerns about a deterioration in the quality of their loan portfolios as a reason for expecting to tighten standards over the remainder of the year.
The staff provided an update on its assessment of the stability of the financial system.
- The staff judged that the banking system was sound and resilient despite concerns about profitability at some banks.
The staff judged that asset valuation pressures remained moderate.
- In particular, the staff noted that the equity risk premium and corporate bond spreads declined over the past few months but remained near historical medians. Valuations in both residential and commercial property markets remained elevated. Rising borrowing costs had contributed to a moderation of price pressures in housing markets, and year-over-year house price increases had decelerated.
The staff noted that the CRE sector remained vulnerable to large price declines.
- This possibility seemed particularly salient for office and downtown retail properties given the shift toward telework in many industries.
- The staff also noted analysis that found that while losses to CRE debt holders could be moderate in aggregate, some banks and the CMBS market could experience stress should prices of these properties decline significantly.
The staff assessed that vulnerabilities associated with household leverage remained at moderate levels.
- For nonfinancial businesses, debt relative to nominal GDP declined some but continued to be near a historically high level.
- The ability of nonfinancial firms to service their debt kept pace with rising debt loads and interest rates.
- In terms of financial-sector leverage, going into the period of recent bank stress, banks of all sizes appeared strong, with substantial loss-absorbing capacity as measured by regulatory capital ratios well above levels that prevailed before the Great Recession.
However, the ratio of tangible common equity to total tangible assets at banks—excluding global systemically important banks—had fallen sharply in recent quarters, partly because of a substantial drop in the value of securities held in their portfolios.
- The majority of the banking system had been able to effectively manage this interest rate risk exposure.
- However, the failure of three banks resulting from poor interest rate risk and liquidity risk management had put stress on some additional banks.
- For the nonbank sector, leverage at large hedge funds remained somewhat elevated in the third quarter of 2022, and more recent data from the Senior Credit Officer Opinion Survey on Dealer Financing Terms suggested this fact had not changed.
- With regard to vulnerabilities associated with funding risks, the staff assessed that although funding strains had been notable for some banks, such strains remained low for the banking system as a whole, especially in light of official interventions by the Federal Reserve, the Federal Deposit Insurance Corporation, and the U.S. Department of Treasury to support bank depositors. Outflows of funds from bank deposits in mid-March, which were concentrated at a limited number of banks, had slowed.
Staff Economic Outlook
- The economic forecast prepared by the staff for the May FOMC meeting continued to assume that the effects of the expected further tightening in bank credit conditions, amid already tight financial conditions, would lead to a mild recession starting later this year, followed by a moderately paced recovery.
- Real GDP was projected to decelerate over the next two quarters before declining modestly in both the fourth quarter of this year and the first quarter of next year.
- Real GDP growth over 2024 and 2025 was projected to be below the staff's estimate of potential output growth. The unemployment rate was forecast to increase this year, to peak next year, and then to start declining gradually in 2025. Resource utilization in both product and labor markets was forecast to loosen, with the level of real output moving below the staff's estimate of potential output in early 2024 and the unemployment rate rising above the staff's estimate of its natural rate at that time.
The staff's core inflation forecast was revised up a little relative to the previous projection.
- Recent data for core PCE goods prices and the ECI measure of wage growth—the latter of which importantly influences the staff's projection of core nonhousing services inflation—came in above expectations, and the staff judged that supply–demand imbalances in both goods markets and labor markets were easing a bit more slowly than anticipated.
- On a four-quarter change basis, total PCE price inflation was projected to be 3.1 percent this year, with core inflation at 3.8 percent.
- Core goods inflation was projected to move down further this year and then remain subdued, housing services inflation was expected to have about peaked in the first quarter and to move down over the rest of the year, and core nonhousing services inflation was forecast to slow gradually as nominal wage growth eased further.
- Reflecting the projected effects of less tightness in resource utilization, core inflation was forecast to slow through next year but remain moderately above 2 percent. With expected declines in consumer energy prices and a substantial moderation in food price inflation, total inflation was projected to run below core inflation this year and next. In 2025, both total and core PCE price inflation were expected to be at about 2 percent.
The staff continued to judge that uncertainty around the baseline projection was considerable and still viewed risks as being determined importantly by the implications for macroeconomic conditions of developments in the banking sector.
- If banking-sector stress were to abate more quickly or have less of an effect on macroeconomic conditions than assumed in the baseline, then the risks would be tilted to the upside for economic activity and inflation, a scenario that the staff viewed as only a little less likely than the baseline.
- If banking and financial conditions and their effects on macroeconomic conditions were to deteriorate more than assumed in the baseline, then the risks around the baseline would be skewed to the downside for economic activity and inflation.
- On balance, the staff saw the risks around the baseline inflation forecast as tilted to the upside, as an upside economic scenario with higher inflation appeared more likely than a downside scenario with lower inflation, and because inflation could continue to be more persistent than expected and inflation expectations could become unanchored after a long period of elevated inflation.