The Federal Reserve’s decision to increase of the US interest rate by 25bps makes a hard landing dramatically more likely, says Anna Stupnytska, global economist at Fidelity International.
The Fed hiked 25bp in its March meeting, which must have been an exceptionally challenging policy decision in light of the ongoing banking turmoil. The decision to go ahead with a hike is a signal of the Fed’s confidence in its ability to contain financial instability while at the same time keeping sharp focus on taming inflation.
The Fed is following the ECB’s template – hiking while switching to a more cautious meeting-by-meeting approach. The Fed could have paused using ongoing stress in the banking system as a valid reason to take some time out. But that could potentially put the Fed’s commitment to taming inflation in question and damage its credibility, a risk the FOMC participants decided not to take at this point. Instead, the key risk for the Fed now is that this hike proves counterproductive, further exacerbating concerns about financial instability and fuelling market turmoil.
As the crisis in the banking system continues to unfold, we believe the likelihood of a hard landing scenario – our base case for some time – has risen dramatically in recent days. The current market stress, a symptom of the size and speed of policy tightening to date, is feeding wider spill overs through the bank lending channel to the real economy.
The Fed’s reaction function remains the crucial determinant of the path from here. Any signs of easing inflation pressures and cooling labour market constraints in coming weeks would be the Fed’s saving grace, allowing them to execute the long-awaited pivot and signal the end of the cycle. If inflation remains hot, the Fed will likely attempt to continue the policy of tool separation in order to juggle both price stability and financial stability, trying to convince markets there is no trade-off between them. But given the role of markets and sentiment in policy transmission, this trade-off is alive and well, and if it gets even sharper, markets will test the Fed until it blinks – and finally exercises the ‘Fed put’.
We still favour a cautious stance expressed through an underweight to credit and an overweight to cash. The end of the Fed’s tightening cycle is drawing near, and we are mindful that this has the potential to cause a relief rally in risk assets in the near term.
However, we believe that the significant amount of tightening already enacted, slowing growth, high inflation, and now the stresses in the banking sector warrant a defensive approach.
We still broadly favour EM over DM, although tightening lending standards in the US and Europe are a headwind for EM FX. The China reopening story is still intact, meaning China could be a useful diversifier if DM growth stalls or banking stresses intensify.
[Main image: nico-smit-Q1tAFjL34C4-unsplash]
