The Fed’s New Predicament: Tame Inflation While Preventing Financial Chaos

Chaos in the banking sector has led to calls for the Federal Reserve to halt or even reverse the pace of monetary tightening. Meanwhile, economic data for February shows that the labor market remains strong and inflation remains rampant, underlining the amount of work the central bank still needs to do to tame price growth.

The challenge for the Fed is figuring out how to support banks and calm inflation at the same time, without causing a recession. While the Fed could theoretically take a dual-track approach, the risk is that continuing to raise interest rates will further stress the already weak financial sector.

“Their job has become significantly more complex,” says Mark Zandi, chief economist at Moody’s Analytics.

Arguments in favor of a pause in monetary tightening focus on concerns that recent bank failures and rising recessionary expectations will lead to a decline in consumer and business spending, at least marginally, and that the Fed will have to wait and see if its emergency lending measures succeed in stemming the turmoil. Banking before they raise interest rates more.

Some economists also warn that the collapse of two regional banks is likely to make banks less willing to lend, thus tightening credit conditions and doing some Fed action to slow the economy. Economists at Goldman Sachs estimated on Wednesday that the “further tightening in lending standards” they expect as a result of continued small bank pressure will have the same effect of roughly 25 to 50 basis points, or 0.25 to 0.50 percentage point, off the interest rate. He increases.

But the banking turmoil does not happen in a vacuum. It happens because inflation remains well above the Fed’s 2% target and is even accelerating through some measures. While financial volatility is cause for caution, economic data released since it started to point to the need for more rate hikes.

February CPI data, released on Tuesday, showed core consumer prices rose 0.5% for the month. Retail sales data released on Wednesday showed underlying strength in core control sales, which rose 0.5%. On Thursday, new applications for unemployment insurance fell while new homes rose. Both exceeded expectations and confirmed continued economic resilience.

The European Central Bank also moved forward on Thursday with plans it laid out before the banking chaos began, raising interest rates by half a point. The action indicates that at least some central bankers feel they can continue to tighten monetary policy and tackle inflation while still navigating new uncertainties and stabilizing the financial sector.

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all of which It means the Fed cannot give up its fight against inflation, even as it addresses the issue of financial stability among regional banks, economists say. This means the Fed needs to raise interest rates by a quarter point at its next meeting, despite last week’s chaos.

“The thing that’s still true here, even though we’ve got a lot of news coming in, is that inflation is still very much rooted in sticky service-sector categories that are really hard to crack,” says Thomas Simmons, an economist with Jefferies. “If the Fed stops here, I am very concerned that inflation expectations will rise again.”

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For the Fed, pausing its tightening campaign now would run counter to Chairman Jerome Powell’s pledge that the central bank would not give up its battle for price stability until inflation returns to the 2% target, economists say. Abandoning the hike would send a message that the central bank is not yet convinced it has done enough to restore financial stability.

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What’s more, if the pause is interpreted as a signal that the Fed is done raising interest rates, it could contribute to a view that rampant price growth is here to stay. This, in turn, could cause a shift in consumer behavior that would eventually make it harder to slow inflation to 2%.

“The strongest argument for continuing to raise rates at the meeting a week from now is, if they don’t, markets will ask, ‘Is this the end of the Fed’s rate hikes?” “If this is the end of the Fed’s rate hikes, inflation is still very high and the economy still looks overheated,” says Andrew Hollenhorst, Citi’s chief US economist. So why should there be confidence that inflation will fall to 2%? “

What the Fed will do remains unclear, not least because a decision is still about a week away. But investors are starting to get around to the idea of ​​a quarter-point rate hike, with data from CME FedWatch tool On Thursday afternoon, there is a greater than 80% chance that this volume will increase.

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Traders were spooked by the recent turmoil, and stock markets tumbled on Wednesday before recouping most of their losses. But economists say the collapse of the Silicon Valley bank has not changed their views on the economy significantly. While some economists spoke with Barron He said the risks are now more weighted to the downside, that a recession could come a little sooner than previously expected, and that none of them had made significant changes to their growth forecasts or were predicting an imminent crash.

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Instead, they have mostly viewed the turmoil in the banking sector — at least for the time being — as more of an isolated weakness than a symbol of widespread economic disaster.

“Despite the extreme uncertainty, given how quickly events are developing, the impact of bank failures on the economic outlook should be on the sidelines,” Zandi wrote this week. “The economy will struggle this year and next, and it will still be vulnerable to events like those of the last several days, but it is likely that it will not be this banking crisis that will push the economy into recession.”

Write to Megan Cassella at megan.cassella@dowjones.com

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