Fed will deliver 25 bps rate hike, but decision is on a 'knife edge,' economist says

Abrdn U.S. research economist Abigail Watt joins Yahoo Finance Live to discuss the possible moves for the Federal Reserve at the end of its March FOMC meeting.

Video Transcript

- Well, constructive action by regulators to support the US banking system after Silicon Valley Bank's collapse hasn't been enough to calm markets or ease insolvency fears among investors or bank depositors. Still, officials are focusing on restoring confidence. Treasury Secretary Janet Yellen spoke on the subject yesterday in her keynote address at the American Banking Association's Washington Summit. Take a listen.

JANET YELLEN: Our banking system is sound, even as it's come under some pressure. As I indicated, this is different than 2008. 2008 was the solvency crisis. Rather, what we're seeing are contagious bank runs. We demonstrated last week that the federal government is resolutely committed to taking actions that will mitigate financial stability risks where that's necessary. And every step we have taken has been intended to reassure the public that our banking system is resilient and that we stand behind the banking system.

- Well, joining us now to discuss the path ahead as the Fed looks to balance the bank stability crisis as well as inflation is Abrdn Research Economist Abigail Watt. Abigail, thank you for joining me in this morning. So as we look at this balancing act, what are you expecting to hear from Jay Powell in terms of the narrative? We know investors will all be listening very closely.

ABIGAIL WATT: Yeah, look, I think this, obviously, as you've said, is a really pivotal meeting for the Fed. Our expectations are that the Fed will deliver a 25-basis-point hike. But clearly, I mean, the decision is likely on a knife edge for the Fed today. And I think in terms of their communication and how they handle the press conference, I think if they choose to deliver that 25-basis-point hike, then I think they're likely to focus a lot more on the financial stability concerns, pushing towards staying around the different tools that they have to deal with those financial stability concerns, and, I guess, separating the fight on inflation from the ongoing turmoil in the banking sector.

But if they choose to not hike, then I think the press conference tone could be very different. I think they'll likely be much more hawkish in their stance in that meeting, in their press conference. And I think that's likely because they still have that inflation fight to go somewhat. And I think they would be conscious that that pause should be predicated on the View that they will then return to hiking again once markets have calmed a little.

- And it's tough because the Fed was accused of being behind the ball when it came to recognizing how sticky inflation was going to be. So now at this point, then, depending on what they do, as we've seen across the camp, a lot of different views on what the Fed could and should do at this meeting. How much of the Fed's credibility is on the line?

ABIGAIL WATT: I think it's a really good question. And I think this is perhaps slightly why we're erring towards the 25-basis-point hike because I think the fundamentals in the economy-- we saw stickier inflation. We've seen the labor market tightness persisting. And we've seen activity actually holding up fairly well into the turn of the year. And so I think in terms of the Fed's credibility, they'll be really conscious of that inflation fight and the fact that is ongoing.

And I think if you think about the turmoil in the banking sector, I think as well, not hiking, does that suggest to investors that the Fed are more concerned than they perhaps-- than they perhaps currently think they are? And I think that will be a really important balancing act for the Fed today.

- And, of course, everyone keeping an eye on recession risk. Data from Bank of America research is seeing an uptick in recession risk. 42% of fund managers surveyed predict a recession within the next 12 months. It was just at 24% in February. How have your recession expectations changed?

ABIGAIL WATT: So we've been expecting the US to enter a recession since June last year. We originally projected that they would enter that recession by Q2 this year. We saw the strength of the data at the beginning of the year. And we pushed that back.

But I think there's a question as to whether some of the turmoil you've seen in the banking sector actually pulls forward the timing of that recession, so whether we see the US enter a recession over the summer instead. I think in terms of how that's shifting, how this is shifting our expectations of a recession, I think the way that we think about it is actually that some of the tightening that we're likely to see in credit conditions off the back of the banking sector turmoil might do some of the Fed's work for it. We might see that tightening in financial conditions feed into the real economy a little faster. And then the Fed likely doesn't have to hike rates as much as we had originally expected them to.

- So then beyond this meeting, then, we know that Jennifer was talking about that formula of trying to manage inflation while also trying to decide what to do with quantitative tightening or easing there. What is your outlook on that?

ABIGAIL WATT: So we're, given we're expecting the US to enter a recession-- and that recession that we're predicting is a run-of-the-mill recession. We're expecting a peak-to-trough decline in activity of around 2%. We expect that will have labor market impacts. And we think that, ultimately, some of the loosening in the labor market that will happen through that recession will lead to inflation eventually undershooting the Fed's target.

And in that environment, we think it's highly likely that the Fed will cut rates back down to the zero lower bound. And this is somewhere where we've had a little bit of pushback in terms of the extent to which we think the Fed will loosen policy. But I think it's likely that, given the recession that we're forecasting, if that is realized, then we think the Fed will have to loosen policy again through the next-- through 2024.

- And as we look at how some of these central banks are really addressing this, I mean, we saw the ECB determined to stay the course, even in the midst of Credit Suisse-- Credit Suisse's collapse, still going for that 50-basis-point hike. What are we seeing in terms of central bank coordination on this? Or are we in a sort of uncharted territory?

ABIGAIL WATT: Yeah, I think it's a really interesting question because I think it also has implications for the Bank of England tomorrow. And I think the ECB kind of paved the way for the path for the Fed in terms of being able to separate the financial stability and the inflation concerns at today's meeting. And I think if the Fed were to not hike 25 basis points today, then I think that that has knock-on implications for the Bank of England's meeting tomorrow.

Obviously, we saw the upside surprise in the inflation data out at the Bank of England today-- out of the UK today. And I think that, all things said, I think the Bank of England should be hiking 25 basis points tomorrow. But I do think you're right, that there is perhaps a knock-on effect if the Fed do not hike today.

- We'll certainly be keeping an eye on that. Abrdn Research Economist Abigail Watt, thank you for joining me in this morning.

ABIGAIL WATT: Thank you.