Fed: Banking crisis ‘unknown unknowns’ pose risks to economy, economist says

Fed faces ‘unknown unknowns’ from banking crisis, economist says

Video transcript

DAVID BRIGGS: So what's on deck for the Fed this week? Goldman Sachs now saying, "in light of the stress in the banking system, we no longer expect the FOMC to deliver a rate hike at its next meeting." That's on March 22. Citi and JP Morgan, meanwhile, do expect another 25 point hike. New data from CME's FedWatch Tool revealing that nearly 3/4 of its market is anticipating a 25 point basis hike.

Let's talk about that with EY Chief Economist Greg Daco. Good to see you, my friend. What is your expectation at this next Fed meeting?

GREG DACO: Well, I think it's likely that the Fed will proceed with a 25 basis point rate hike, as I've discussed in my recent note. I think the Fed is likely to approach a dual track approach, distinguishing financial stability tools from price stability tools, so wanting to keep that hawkish tone in terms of inflation. We know the Fed continues to view the data as being excessively hot on the inflation front, excessively tight on the labor market front. And I think that will likely push the Fed to proceed with a 25 basis point rate hike despite the stress.

SEANA SMITH: Greg, will that be a mistake?

GREG DACO: Yeah, I don't think that's necessarily the right way to proceed in the current environment. I think we would be better off, essentially, in an environment where there were a pause in the Fed tightening environment. We have, if you look at the totality of data, an environment where inflation is gradually cooling, where the labor market is also cooling. So from an economic perspective, we're seeing that momentum in the right direction.

And then we have a lot of stress in terms of financial markets. It's not just domestic. It's international. And there is a risk of contagion. I've talked a lot about the fact that there are the known unknowns, but there are also the unknown unknowns.

And those are the ones that can hurt. So there's nothing preventing, really, the Fed from taking a step back, holding back, pausing, even if it's a hawkish pause, and not providing any additional forward guidance. I think the dot plot in this current environment is really useless.

DAVID BRIGGS: Even if it were no hike at this next meeting, do you believe that the terminal rate has changed at all so they'd resume the hike at the following meeting?

GREG DACO: Well, I think giving ourselves a little bit more breathing room in terms of observing the totality of economic data, observing how financial conditions evolve over the course of the next few weeks would just serve the right purpose in the current environment. We have a very fluid situation. And let's not forget, the Fed is not holding a dovish stance when it comes to monetary policy. It has tightened rates very aggressively over the course of the past year. We are now well into restrictive territory.

So doing a rate hike at this point versus not doing one is not going to change the game in terms of the inflation outlook, would just provide a little bit more breathing room to assess the need to tighten monetary policy further to resolve the issue or the uncertainty with regards to the balance sheet runoff. And I don't think, again, providing any type of medium expectations for the Federal funds rate will provide any help or guidance, useful guidance, at this stage when it comes to interest rate projections.

SEANA SMITH: Greg, how do you see the panic that we certainly have seen play out in the banking sector, how do you see that affecting economic activity up until this point?

GREG DACO: Well, I think we know one thing for sure is that before this event, we were in an environment where economic growth was slowing. We were not in the midst of any type of retrenchment in private sector activity. We continue to see a labor market that was relatively resilient still adding jobs. But there were decisions being made in terms of hiring, in terms of being careful about investment decisions. Those strategic decisions meant that we were in a slowing growth environment.

And we were also noticing some cracks in the foundation of household finances. Credit conditions were something that I've mentioned in the past were-- did warrant some attention. In the current environment, we're likely to see banks step back from credit, tighten standards even more, and be more careful with credit growth. And that is going to have a knock-on effect onto economic activity, likely shaving a few tenths if the situation doesn't worsen. But we are, again, in this very fluid situation where we have to be conscious that it could very well end in a better situation, but it could also end in a worse situation.

DAVID BRIGGS: Has the last week to 10 days, Greg, changed your perception on the likelihood of a recession?

GREG DACO: I think all else equal, it does increase the odds of a more pronounced slowdown in economic activity. I mean, we were already on the verge of seeing this near stall in the economy. If you look at final demand growth, excluding trade, excluding inventories, and excluding government, we were in a very soft position at the end of last year.

This recent set of events is going to constrain credit growth, constrain consumer spending, and business investment and will increase the odds that we do end up in a recession. It could be a mild recession still because there are a lot of backstop being taken very early on from the different monetary authorities around the world. But still, I do think-- feel as though this type of environment increases the odds of a recession going into the rest of the year.

SEANA SMITH: All right. Greg Daco, always great to have you. Thanks so much.

GREG DACO: Pleasure.