US Weekly Economic Commentary: Fed keeps thumb on inflation after banking turmoil

During a light week of relatively uneventful data releases, we nudged down our tracking forecast of first quarter real GDP growth by 0.1 percentage point, to 0.5%.

Sales of both new and existing homes turned up in February, likely in response to the recent softening of mortgage rates, while shipments of civilian aircraft and manufacturing inventories were reported slightly weaker than we expected. What little data are available suggest the economy didn't falter in March and that, despite highly publicized layoffs announced in the tech sector, labor markets remain tight.

The "flash" estimate of the S&P Global composite PMI rose to a ten-month high. Strength was especially evident in sub-indices for the service sector, and the index for manufacturing output also rose to a level indicating expansion in that sector. Unemployment claims, both initial and continuing, remained at cyclically low levels through mid-month.

In the week's most newsworthy event, the Federal Open Market Committee (FOMC) met on March 21-22 amid speculation about the balance the Committee would strike between its ongoing effort to lower inflation toward 2% and the need to support financial institutions following the collapse of Silicon Valley Bank (SVB). At the meeting's conclusion, the Fed announced a 25 basis point increase in its policy rate to the range of 4.75% to 5%.

New headwinds

The Fed acknowledged that a contraction of credit emanating from turmoil in the banking sector was likely to create new headwinds for the economy. Perhaps in recognition of this new risk, the Fed's updated Summary of Economic Projections showed a small downward revision of GDP growth this year, from 0.5% to 0.4% measured fourth-quarter-to-fourth-quarter, followed by a larger downward revision for next year, from 1.6% to 1.2%. In response, Treasury yields edged down over the week, while the S&P 500 index rose 1.4% on the week.

In the end, the rate hike was what we, and financial markets, expected. Nevertheless, from just a few weeks earlier it represented a marked shift in sentiment about prospective monetary policy.

Prior to the demise of SVB — and given early-year indications of both economic strength and stubbornly high inflation — expectations were shifting towards the view that the FOMC might hike rates 50 basis points at the March meeting, on the way to a peak funds rate of 5.5% or higher. Then, the Committee's post-meeting announcement contained both softened language on the need for further rate increases and warnings about new financial headwinds.

In response, markets have now priced in 100 basis points worth of cuts in the federal funds rate by the January 2024 meeting of the FOMC, a notably earlier reversal than suggested by the Fed's updated "dots plot." This seems consistent with a view that economic growth might decelerate sharply in coming months, or that the Fed might (temporarily) shift the emphasis of policy away from squeezing down inflation to managing the new risks and uncertainties emanating from the banking sector.

Revisions ahead

Our April forecast round begins this week with BEA's third estimate of fourth-quarter GDP. Based on available data, we expect to revise up our estimate of first quarter GDP growth by about a percentage point from our March forecast (from -0.4% to +0.5%). That, by itself, would raise growth for 2023 by about 1/4 percentage point, measured either year-over-year or fourth-quarter-to-fourth-quarter.

What remains uncertain is the extent to which recent developments in the banking sector might encourage us to revise down our forecast for growth over the remaining quarters of the year, or even into 2024.

Conflicting forces are at play. Some financial conditions appear more supportive of growth than they did a month ago. Treasury yields will open the second quarter notably lower than in last month's forecast, the dollar is down, and stock prices will close the first quarter close to the March forecast. Against that, private credit spreads have widened, and the equity risk premium has jumped.

This shift towards "risk-off" sentiment broadly could delay spending decisions, slowing growth. We expect the actions of the Fed and the FDIC are sufficient to significantly mitigate systemic risks to the banking system. Additional actions may be needed to contain what might be irrational contagion effects spreading from the failure of SVB. And, what's difficult to assess quantitatively is the potential negative impact on GDP of a general contraction of credit that could arise from the recent turmoil in the banking sector.

We will be watching with considerable interest the Fed's next survey of Bank Senior Lending Officers, while we monitor changes in bank balance sheets, especially those of small banks, for evidence of deposit outflows that could signal tightening credit, especially at regional banks.

This week's economic releases:

• Nominal goods deficit (March 28): We expect the nominal goods deficit to widen by $4.6 billion in February to $95.2 billion.

• Nominal personal income (March 31): We expect nominal personal income was flat in February, while nominal personal consumption expenditures (PCE) rose 0.2% and real PCE declined 0.1%.

• Conference Board Consumer Confidence Index (March 31): We expect that the index fell 2.0 points to 100.9 during March, as the recent turmoil in the banking sector is likely to weigh on confidence.

• Real GDP (March 30): Factoring in our read on the GDP source data that have been reported over the last few weeks, we look for fourth-quarter 2022 GDP growth to be revised down to 2.6%.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.