Fed Expects Banking Crisis to Trigger Recession Later This Year, Minutes Reveal

Federal Reserve Chair Jerome H. Powell testifies before a U.S. Senate Banking, Housing, and Urban Affairs Committee hearing on “The Semiannual Monetary Policy Report to the Congress” on Capitol Hill in Washington on March 7, 2023. Kevin Lamarque/Reuters

Federal Reserve staff are projecting that the banking crisis would trigger a recession later this year, minutes from the March Federal Open Market Committee (FOMC) policy meeting revealed.

As expected, the turmoil in the banking sector was the main focus of last month’s policy meeting, with many Fed participants expressing concern that the collapse of Silicon Valley Bank and Signature Bank would result in tighter credit conditions, which would then weigh on economic activity, hiring, and inflation. But no economic data was available at the time to immediately determine how the events in the banking sector would affect the broader economy.

For months, the U.S. economy had been projected to show tepid real GDP growth and softening of the labor market. However, central bank staff now expect that the economy will slip into a recession later this year and then enjoy a recovery in the following two years.

“Given their assessment of the potential economic effects of the recent banking-sector developments, the staff’s projection at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years,” the meeting summary stated.

“Real GDP growth in 2024 was projected to remain below the staff’s estimate of potential output growth, and then GDP growth in 2025 was expected to be above that of potential. Resource utilization in both product and labor markets was forecast to be much less tight than in the January projection.”

Because of the events that transpired early last month, several officials recommended pausing rate hikes. Other officials argued that the rate-setting committee needed to adopt policy flexibility.

“In light of the highly uncertain economic outlook, participants underscored the importance of closely monitoring incoming information and assessing the implications for future monetary policy decisions,” the minutes said.

“Participants noted that it would be particularly important to review incoming information regarding changes in credit conditions and credit flows as well as broader changes in financial conditions and to assess the implications for economic activity, labor markets, and inflation. Several participants emphasized the need to retain flexibility and optionality in determining the appropriate stance of monetary policy given the highly uncertain economic outlook.”

The exterior of the Marriner S. Eccles Federal Reserve Board Building is seen in Washington on June 14, 2022. Sarah Silbiger/Reuters

On the inflation front, meeting participants expect prices to continue falling. However, officials agreed there was little evidence to confirm a disinflation trend for core services, except for the housing market.

Central bank officials supported a restrictive policy stance because of the upside risks to the inflation outlook.

“Several participants noted the importance of longer-term inflation expectations remaining anchored and remarked that the longer inflation remained elevated, the greater the risk of inflation expectations becoming unanchored,” the minutes stated.

Last month, the Fed raised interest rates by 25 basis points, lifting the benchmark federal funds rate (FFR) to a range of 4.75 and 5.00 percent.

Stop or Push Ahead?

In the last year, the U.S. central bank has increased the policy rate by 475 basis points, and it now stands at its highest level since late 2007.

Investors expect that officials would pull the trigger on one more quarter-point rate hike at next month’s FOMC meeting, especially as the annual inflation maintains its downward trend, according to the CME FedWatch Tool.

The Fed’s Survey of Economic Projections (SEP) (pdf) shows that Fed Board members and regional bank presidents anticipate the median fed funds rate to be 5.1 percent and then decline to 4.3 percent in 2024 and 3.1 percent in 2025.

However, there is a widening divergence between Fed policymakers, arguing that inflation remains too elevated, particularly the core consumer price index (CPI), which eliminates the volatile food and energy sectors.

In March, the annual core inflation rate rose to 5.6 percent, up from 5.5 percent in February. Services inflation also remained stubbornly high at 7.3 percent in March, although it was down from 7.6 percent.

Richmond Fed Bank President Thomas Barkin stated on Wednesday that he is still waiting for inflation to “crack.”

“It was pretty much as expected. I put particular focus on the core, which is still running a little over 5 percent year over year. And you know, we had some good news on energy, but there’s still more to do, I think, to get core inflation back down to where we'd like it to be,” Barkin told CNBC.

“I’m waiting for inflation to crack. It’s moving in the right direction ... but in the absence of a month or two months or three months with inflation at our target, it’s hard to make the case that we’re compellingly headed there.”

The Philadelphia Fed Bank President Patrick Harker recommends bringing the FFR to above 5 percent and then letting it sit there for a while.

“Since the full impact of monetary policy actions can take as much as 18 months to work its way through the economy, we will continue to look closely at available data to determine what, if any, additional actions we may need to take,” Harker said in a speech on April 11 at the Wharton Initiative on Financial Policy and Regulation.

Chicago Fed President Austan Goolsbee urged his colleagues to practice “prudence and patience,” hinting that the institution needs to hit the pause button on its tightening efforts as the banking system experiences financial stress.

“Given how uncertainty abounds about where these financial headwinds are going, I think we need to be cautious,” Goolsbee said in an April 11 address to the Economic Club of Chicago. “We should gather further data and be careful about raising rates too aggressively until we see how much work the headwinds are doing for us in getting down inflation.”

The FOMC will hold its two-day policy meeting on May 2 and 3.