For The Fed, This Is No Time For Surprises

Authored by Simon Flint via Bloomberg,

There is an argument that the Fed will stick to its inflation-fighting mission, because it needs to focus on restoring its credibility, and this keeps a 50bps hike in play for March.

However, this could be a major policy error and hence the basic choice for the central bank remains between 25bps and zero.

In detail:

At current market pricing, a 50bps increase would be a significant surprise.

Central banks only like to surprise if they are trying to gain credibility or alter expectations profoundly. This was true of Kuroda’s BOJ over 2013-2016 especially.

Of course, of late, the Fed has been trying to re-establish sufficiently hawkish credentials and has tended to be more muscular than markets have expected.

However, one shouldn’t think of this as normal.

Surprises create uncertainty, and uncertainty is generally inimical to stable macro conditions.

This is especially true now.

A hawkish surprise would be extremely risky given the extreme uncertainty.

I also don’t accept that zero-25bps looks weak on inflation.

Aside from the fat-tail risk, there’s very likely to be deposit competition and tighter lending standards which will have real macro effects.

A rigorous Goldman Sachs report on March 15 argues that “the incremental tightening in lending standards that we expect from small bank stress would have the same impact on growth as roughly 25-50bp of rate hikes would have via their impact on market-based financial conditions.”

The risk/reward in this case seems clear.

The Fed needs to weigh the small credibility cost of not adhering to Powell’s recent guidance, against the potentially very large credibility cost of presiding over a bank sector-induced economic slump.

On the other hand, a significant dovish surprise might suggest that the Fed knows something very worrying that the markets don’t, and this signaling effect would be potentially just as risky as being too hawkish.