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 an anchor bite.
Will the Fed back its inflation-fighting rhetoric and raise interest rates again, despite setbacks from the collapse of Silicon Valley Bank? Or does it prioritize financial stability in a period of uncertainty in the banking system?
Most economists and investors expect the central bank to raise its key short-term rate by a quarter of a percentage point as pressure on the financial sector has eased somewhat in recent days. Markets will nod to the latest turmoil by supporting the expected half-point increase before the crisis, while the central bank’s aggressive rate hike campaign will add another peak to the campaign.
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But “it’s a close call,” says Kathy Postjanczyk, chief economist at Nationwide Mutual.
Another rate hike would be the Fed’s 4½ basis point hike last year – the most in four decades. It sharply increased consumer borrowing costs for mortgages, auto loans and credit cards, and dented the stock market, while also raising minimum fees for bank savings accounts.
“The failure of Fed Chair Powell and most policymakers to bring inflation back to the 2% target is not their legacy,” Gregory Taco, chief economist at EY-Parthenon, wrote in a note to clients.
But many top economists, including Bostjancic and Goldman Sachs, expect the Fed to take a more cautious path and hold off on rate hikes.
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Bostjancic says policymakers believe the crisis itself is “going to reduce economic activity and inflation.” “‘We’re going to pause to assess the unique stresses'” to the financial system.
In a research note, Goldman economist David Mericle adds, “The correlation between a single (quarter-point) hike and the future path of inflation is very weak. Then.”
What are central bank rate forecasts?
The central bank is expected to release new forecasts for the economy and fed funds rate on Wednesday. So, while the Fed could keep rates steady at 4.5% to 4.75%, Goldman believes officials will signal three more quarter-point rate hikes to 5.25% to 5.5% by July. Barclays expects the Fed to forecast a peak rate of 5% to 5.25%.
Any forecast would show that the central bank is still aiming to raise rates to reduce inflation and is standing by caution for the time being. However, both estimates are below the peak rate of 5.5% to 5.75% that markets had predicted before the SVB’s fall.
Now, markets appear to believe the crisis is worse than it appears and Postjanczyk says the central bank will scale back its rate hikes. They predicted the central bank would raise rates on Wednesday and then pause before cutting rates three times starting in July, saying banking turmoil, a slowing economy and rate hikes could lead to a recession within months.
Normally, central bank officials signal their plans in a way that doesn’t surprise markets, but the SVB crisis unfolded during a quiet period when they were barred from communicating with the public.
Here are four reasons why the Fed should raise rates by a quarter point, and four reasons to hold off.
Why the hike?
The banking crisis has subsided
The crisis erupted when struggling tech companies began withdrawing their money from Silicon Valley banks for financing needs, forcing SVB to sell bonds that had fallen in value after the central bank’s sharp rate hikes. The bank’s capital losses resulted in more than $250,000 in deposits that were not FDIC insured and led to additional customers withdrawing their money.
Similar bank runs led to the demise of New York’s Signature Bank and threatened First Republic Bank, which recently received $30 billion in deposits from JPMorgan and other big banks. Meanwhile, UBS bought a teetering Credit Suisse.
The central bank and other regulators announced that the SVB would provide funding to ensure depositors have access to their money in signature and other banks that pose a risk to the financial system. They also released a lending facility so other regional banks could borrow money to recoup uninsured depositors’ money.
Regional bank stocks fell last week, but rebounded somewhat on Monday. Barclays said only a handful of financial institutions were exposed to such problems because their profiles matched SVB’s. In other words, many of their depositors are uninsured and large portions of their assets are in securities, whose values have collapsed.
“We are now seeing tentative signs of consolidation,” Barclays wrote in a note to clients.
The economy and inflation are strong
Late last year, job and wage growth slowed and inflation showed signs of easing. But employment picked up earlier this year and inflation picked up in January and February. Before the crisis, Powell indicated that a half-point rise was possible.
“Given the strength of the labor market and the persistence of consumer inflation, it’s hard to argue that it’s time for the Fed to pause,” Bank of the West chief economist Scott Anderson said. “Furthermore, if the central bank pauses after their bad rhetoric in recent weeks, it will do even more damage to the central bank’s credibility.”
A pause could signal the central bank is worried
Regulators struggled to assert that the banking system was stable.
“Pausing (the Fed) would imply concern, which may not be the case,” says UBS.
And it would cause depositors in other regional banks to move money to the big banks, exacerbating the crisis.
The ECB raised rates sharply last week
The European Central Bank raised its key rate by half a point last week despite Credit Suisse’s troubles.
Barclays says the fact that “markets have not reacted negatively” to the move will be “a measure of reassurance” for the central bank.
Why should the central bank pause?
SVB does the job of a crisis central bank
As regional banks face increased customer withdrawals, or at least the risk of them, banks are expected to further tighten their lending standards, making it harder for consumers and businesses to get credit, Goldman says. That could hurt economic growth and soften inflation so the central bank doesn’t have to raise as much. Banks are already reluctant to lend because of the risk of a recession this year.
Goldman Sachs said tighter credit conditions would equate to a quarter- to half-point increase in the central bank rate.
The banking crisis has subsided, not disappeared
According to a Goldman analysis of public records, clients are moving money from banks to money market funds. Goldman says transfers from regional banks to larger firms are less clear.
But banks borrowed $153 billion from the central bank’s discount window last week, up from $4.6 billion the previous week. And the Fed’s new credit facility has provided about $12 billion in loans. Banks may seek financing to offset increased borrowing, withdrawals, or limit those possibilities.
“Overall, the magnitude of the Fed’s emergency credit increase underscores that this is a very serious crisis in the banking system that will have a significant impact on the real economy,” Capital Economics wrote to clients.
Fee hikes can add stress
A rate hike could compound the conditions that led to bank runs by further reducing the price of bonds owned by regional banks, threatening their financial health and triggering more runs.
Worse, the Fed’s own aggressive hiking campaign fueled the problem, giving Fed officials reason to be especially wary, Postjanczyk says.
Central funding, fiscal targets at cross-purposes?
By raising rates after the bank took steps to ease pressure, Capital Economics said, “the Federal Reserve’s monetary policy goals could be seen as conflicting with its financial stability goals.”
“After a week to support financial stability, we would be surprised if policymakers undermined their efforts with a rate hike,” Goldman said.
