Powell signals bigger hikes are back

Jerome Powell told the Senate Banking Committee that the Federal Reserve is ready to go back to rate rises of 50 basis points if the economic data stay hot. It was a sharp change of tone from the Fed chair, whose earlier appearances had stressed a steady, data-dependent pace. Bond markets reacted fast. The two-year Treasury yield rose above 5.0 per cent for the first time since 2007, and share prices fell as investors abandoned hopes of a soft landing, more or less on the spot.

Frustration explains the shift. After slowing to a 25-basis-point rise in early February, the committee watched financial conditions loosen and risk assets rally. January then brought blowout payrolls and firmer inflation figures.

A year of catching up

The Fed began this cycle late and has spent a year making up ground. It lifted its target range off the floor in March 2022, then delivered four successive increases of 75 basis points between June and November, followed by a half-point step in December. The February move took the range to 4.50 to 4.75 per cent. At his press conference that month Powell said the process of disinflation had begun, and markets took the remark as permission to rally.

That reading was always generous. Goods prices had turned, helped by mended supply chains and cheaper freight, but the services side of the basket, where wages dominate costs, had barely moved. The chair's new testimony amounts to an admission that the February reading was premature.

How the numbers turned

The January data did the damage. Payrolls rose by 517,000, the unemployment rate fell to 3.4 per cent, and core PCE inflation came in at 4.7 per cent after upward revisions to the previous months. In December the median official had pencilled in a peak rate of 5.1 per cent. Powell told senators that the ultimate level of rates was likely to be higher than officials had expected, and futures traders moved sharply toward a half-point increase at the March meeting.

The consumer price index told the same story. Headline inflation for January was 6.4 per cent and core inflation 5.6 per cent, both above what forecasters had expected, and the monthly gains were larger than in the final months of last year. A central bank that had just slowed its pace found the data accelerating underneath it.

Slowing down backfired

By easing off too soon, the Fed weakened the very channel through which its policy works. Powell's testimony was a deliberate correction, meant to jolt investors out of their complacency and restore the committee's standing as an inflation fighter.

The channel matters because the policy rate itself touches little of the economy directly. What bites is the chain it sets off: higher yields on two-year and ten-year Treasuries, wider spreads on corporate bonds, dearer mortgages, lower share prices and a stronger dollar. When markets rallied in January they undid part of that chain, lowering borrowing costs for companies and households while the Fed was still trying to raise them. Talk of larger increases is the quickest way to put the chain back under tension without moving the policy rate at all.

The Fed has changed gear abruptly before. Last June it raised rates by 75 basis points, the first move of that size since 1994, after a hot consumer price report arrived days before the meeting. Officials then showed they would rather surprise markets than be seen to fall behind, and the same instinct is at work now.

The 1994 episode is the closer parallel for bond investors. That year the Fed doubled its policy rate from 3 per cent to 6 per cent in twelve months, far faster than markets had priced, and bond portfolios built on cheap short-term funding took heavy losses. Orange County in California filed for bankruptcy in December after its leveraged bond fund collapsed. The lesson was that the damage from a faster pace shows up first in whoever has borrowed short to hold long.

Who pays for the higher peak

The open threat of 50-basis-point moves takes away the predictability that corporate treasurers had been counting on. With the projected peak rate now above 5.5 per cent, companies with floating-rate debt have to redo their sums on refinancing.

The heaviest burden falls on leveraged borrowers in the loan and private credit markets, whose coupons reset with short-term rates, and on households carrying credit card balances. Savers and money market funds are the winners, since yields at the front of the curve now pay more than at almost any point since 2007. The dollar also gains, which tightens conditions for foreign borrowers who owe in it.

The transmission to floating-rate borrowers is quick. Leveraged loans typically reset against a short-term benchmark every one to three months, so a half-point increase in March would appear in coupons before the summer. Fixed-rate issuers are spared until their bonds mature, which is why the pressure lands first on the private-equity-owned companies that lean hardest on loans.

Banks near the limit

Speeding up rate rises while the yield curve is inverted is risky. The financial system was already under strain from 450 basis points of tightening in twelve months. On Tuesday the gap between two-year and ten-year yields widened past a full percentage point, the deepest inversion since the early 1980s, which squeezes banks that borrow short and lend long.

Banks already carry about $620 billion of unrealised losses on their securities, according to the FDIC's latest figures, and Silvergate, a lender to crypto firms, warned last week that its survival was in doubt after deposits fled. Each rise in short-term yields widens the gap between what depositors can earn in Treasury bills and what banks pay them.

Abroad, the pressure differs

Other central banks are not all moving in step. The European Central Bank raised its deposit rate by half a point in February and said it intended to do the same in March, so a faster Fed need not open a wide transatlantic gap. The Bank of Canada, by contrast, said in January that it expected to hold its rate after eight increases. If the Fed accelerates while some peers stop, the dollar's recent weakness could reverse, which would help American importers and hurt emerging-market borrowers with dollar debts.

What could hold the Fed back

Powell left himself room. He tied faster increases to the incoming data, and January's strength may owe a good deal to mild weather and seasonal adjustment. The February jobs report arrives on Friday, the consumer price index follows next week, and the committee meets on March 21st and 22nd. Soft readings would let the Fed stay at 25 basis points while still raising its projected peak.

The strongest counterargument is the lag. Monetary policy is generally thought to take a year or more to work through to activity, so much of last year's tightening has not yet reached hiring and spending. A committee that accelerates now risks overshooting on the back of one month of data. That argument would carry more weight if the labour market were showing any strain, and so far it is not. The new dot plot, published after the March meeting, will show how far officials have raised their own estimate of the peak.

Higher short-term yields give depositors more reason to pull money out of regional banks. Powell has shown he will accept a good deal of financial strain to keep inflation expectations in check. With the front end above 5 per cent, a regional bank is likely to crack before the Fed's plans do, and possibly within weeks.