MNI INTERVIEW: ‘Most Dovish Hike’ Shows Fed Likely Done-Swonk

The Federal Reserve’s decision Wednesday shows the central bank is strongly considering a halt to monetary tightening including an end to balance-sheet runoffs because of what could prove a substantial drag on the economy and inflation from the recent banking crisis, Fed advisor Diane Swonk told MNI.

“It was the most dovish hike I could imagine,” Swonk told MNI’s FedSpeak podcast. “If you get a cooling that’s much more rapid without having the economy go into a deep freeze, the Fed could be easing by the end of the year and into next year.”

The Fed could be forced into such a policy reversal if a credit crunch delivers a bigger wallop to the economy than officials had foreseen, she said. Policymakers are trying to estimate the effects of suddenly tighter credit on growth, jobs and inflation – but it’s too soon for a sound judgement.

FOMC members appear worried that rate hikes from zero to nearly 5% in just a year might be excessive in the face of financial turmoil, said Swonk, chief economist at KPMG. “They don’t know how much that will do more than they need to cool inflation and chill the economy,” she said. “Their goal is to chill the economy not send it into a deep freeze.”

PAINFUL END TO SUMMER

The economy could already be entering a period of contraction in the second quarter but “the worst of the pain doesn’t hit until we get over the summer,” Swonk said. (See: MNI INTERVIEW:Fed Could Cut Rates Before Summer-Ex-NY Fed Econ)

Powell and his colleagues kept open the door to future rate increases if inflation proves stubborn but a clear softening of their forward guidance suggested such a prospect is highly conditional – a major change in the outlook from just two weeks prior.

“Their downside risk up until a couple of weeks ago was a repeat of the 1970s and a more corrosive bout of inflation that eroded living standards,” she said. “Now they’re worried about the risk that not only do they cool inflation, they get more of a seizure in credit markets.”

The Fed will have to strongly consider halting the process of winding down its balance sheet if liquidity strains linger, especially as the Treasury market has again been affected, she said.

QUESTIONS AROUND LIQUIDITY

“Liquidity in that market has never been what it was pre pandemic. And we did see in recent weeks it seize up as much as it did during the pandemic,” she said.

“Now some of that was short selling and the market dealing with that but it’s something we’re watching really closely because you can’t have that seize up and not have the rest of the economy going and have the rest of credit markets going.”

Emerging markets with high debt levels and vulnerable to much higher interest rates are also a source of concern, Swonk said.

“There are more fragile emerging markets and that’s where there could be places where we just don’t know what kind of backdoor exposures there are,” she said, citing the Thai baht debacle that sparked the Asian financial crisis and Russian debt’s role in the fall of Long-Term Capital Management.