For the first time in recent memory, the Federal Reserve’s two-day meeting on interest rates, which begins on Tuesday, is shaping up to be worrisome.
Will the Fed support the anti-inflationary rhetoric and raise interest rates again despite the aftershocks of the Silicon Valley bank crash? Or will it prioritize financial stability during a period of uncertainty in the banking system?
With the financial industry’s pressure easing somewhat in recent days, most economists and investors expect the central bank to raise the key short-term interest rate by a quarter of a percentage point. This would signal the recent turmoil by reversing the half-point increase that markets had expected before the crisis while adding another notch to the Fed’s aggressive rate hike campaign.
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But, “It’s a close call,” says Cathy Bostancic, chief economist at Nationwide Mutual.
Another rate hike would add to the Fed’s 4-point hikes in the past year – the largest increase in four decades. This wave sharply increased consumer borrowing costs for mortgages, auto loans, and credit cards, and hit the stock market, while also raising previously meager rates for a bank savings account.
“Fed Chair Powell and most policymakers don’t want their legacy to be a failure to bring inflation down to the 2% target,” Gregory Daco, chief economist at EY-Parthenon, wrote in a note to clients.
But many top economists, including Postjancic and Goldman Sachs, are of the opinion that the Fed will take the more cautious course and pause interest rate hikes.
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Policymakers can see that the crisis itself will “slow down economic activity and inflation,” Bostancic says. “We will pause to assess the unique pressures” on the financial system.
In a research note, Goldman economist David Merkel adds, “The link between a single (quarter-point) hike and the future path of inflation is quite tenuous, and[the Fed’s policy-making committee]could always raise a level at its next meeting only six weeks later.” .”
What are the Fed rate expectations?
Also on Wednesday, the Fed is expected to release new forecasts for the economy and the federal funds rate. Thus, although the central bank could keep interest rates steady at a range of 4.5% to 4.75%, Goldman Sachs believes officials will signal three more quarter-point rate hikes by July to a range of 5.25% to 5.5%. . Barclays expects the Fed to expect a peak rate of 5% to 5.25%.
Either projection would show that the Fed is still intent on increasing interest rates to bring down inflation, and is simply standing by for the time being out of caution. However, both estimates are also lower than the peak rate of 5.5% to 5.75% that markets had expected before the SVB crash.
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Now, though, markets seem to think the crisis is worse than it looks and that the Fed is going to screw up its rate hikes, Bostancic says. They expect the Fed to raise interest rates on Wednesday and then pause before cutting rates three times starting in July, suggesting that the combination of banking turmoil, a slowing economy and higher interest rates will cause a recession within months.
Normally, Fed officials signal their plans so as not to surprise the markets, but the SVB crisis emerged during a quiet period when they were prevented from communicating with the public.
Here are four reasons why the Fed should raise interest rates by a quarter point and four reasons why it should pause.
Why hike?
Banking pressures eased
The crisis occurred when distressed tech companies began withdrawing money from the Silicon Valley bank to meet funding needs, forcing the SVB to sell bonds whose value had plummeted due to sharp interest rate increases by the Federal Reserve. The bank’s capital losses led to additional customers with deposits greater than $250,000 who were not insured by the FDIC to withdraw their funds.
Similar bank runs led to the demise of Signature Bank of New York and threatened First Republic Bank, which recently received $30 billion in deposits from JPMorgan and other major banks. Meanwhile, UBS bought the swing bank Credit Suisse.
The Fed and other regulators have announced that they will provide financing to ensure that depositors of SVB, Signature and possibly other banks that pose risks to the financial system have access to all of their funds. They also unveiled a lending facility so that other regional banks can borrow money to cover withdrawals by uninsured depositors.
Regional bank shares plunged last week but partially recovered on Monday. Barclays says only a handful of financial institutions are exposed to similar problems because their profiles match SVB. In other words, many of their depositors are uninsured and large portions of their assets are in depreciating bonds.
“We are now seeing tentative signs of stabilization,” Barclays wrote in a note to clients.
Economy, inflation was strong
Late last year, there were signs that job and wage growth were slowing and inflation was easing. But job gains jumped early this year and inflation jumped in January and February. Before the crisis, this prompted Powell to hint at the possibility of raising half a point.
“Based on labor market strength and stubbornness over consumer inflation, it’s hard to argue that it’s time for the Fed to pause,” says Scott Anderson, chief economist at Bank of the West. “Moreover, if the Fed stalls after its hawkish rhetoric in recent weeks, it could further damage the Fed’s credibility.”
The pause may indicate Fed concern
Regulators have gone to great lengths to ensure the stability of the banking system.
“A pause may indicate (the Fed’s) concerns that may not be the case,” UBS says.
This could cause depositors in other regional banks to transfer money to the larger banks, exacerbating the crisis.
The European Central Bank raised interest rates sharply last week
The European Central Bank raised its main interest rate by half a point last week despite Credit Suisse’s troubles.
“The fact that markets have not reacted negatively” to the move “will also provide a measure of reassurance” to the Fed, says Barclays.
Why should the Fed stop?
SVB Crisis is doing the Fed’s job
With regional banks facing increased customer withdrawals or at least the risk of one occurring, banks are expected to further tighten lending standards, making it more difficult for consumers and businesses to obtain loans, Goldman says. That would likely hurt economic growth and dampen inflation, so the Fed doesn’t have to raise such a limit. Banks have already been more reluctant to lend because of the increased risk of a recession this year.
Goldman Sachs says the tougher lending terms are equivalent to a quarter to a half point increase in the Fed rate.
Banking turmoil has abated, not gone
Customers were moving money from banks into money market funds, according to a Goldman analysis of public records. Transfers from regional banks to large institutions, Goldman says, are not so straightforward.
But banks took out a record $153 billion in loans from the Fed’s discount window last week, up from $4.6 billion in the previous week. The Fed’s new loan facility has lent about $12 billion. Borrowing indicates that banks may seek financing to cover increased withdrawals or are preparing for this eventuality.
“Overall, the magnitude of the rise in Fed emergency lending confirms that this is a very serious crisis in the banking system that will have significant implications for the real economy,” Capital Economics wrote to clients.
A rate hike could add to the pressure
Raising the interest rate could complicate the conditions that led to a run of banks by lowering the price of bonds owned by regional banks, thus threatening their financial health and leading to more runs.
Even worse, the Fed’s rate hike campaign sparked the problem, giving Fed officials reason to be especially cautious, Bostancic says.
The Fed’s Monetary and Fiscal Objectives at Conflicting Purposes?
By raising interest rates immediately after taking steps to ease banking pressure, “the Federal Reserve’s monetary policy goals could be seen as running at odds with its own financial stability goals,” Capital Economics said.
“We would be surprised if, after just a week of major efforts to shore up financial stability, policymakers risk undermining their efforts with a rate hike,” Goldman said.
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