Inflation has been the predominant topic at the Federal Reserve’s monetary policy meetings for the last two years. This week, however, the recent collapse of Silicon Valley Bank and Signature Bank, and the ensuing financial instability, are at the center of all conversations. Fed Chairman Jerome Powell now faces the dilemma of whether to continue raising interest rates to combat inflation or pause until the financial storm subsides. Most analysts expect the Fed to raise rates for the ninth straight time by a quarter of a percentage point, up to the 4.75%-5% range.
Powell is the first Fed chair to offer explanations at a news conference after each monetary policy meeting. This has allowed him to convey his messages with great precision. For this reason, in addition to the decision on interest rates itself, the market will be very attentive to any references to the banking crisis in the Fed’s statement, and in Powell’s own remarks to reporters later.
Before the sudden death of Silicon Valley Bank, the victim of a run on deposits, Powell was debating whether to raise interest rates by a quarter or by half a percentage point (25 or 50 basis points). Inflation seems somewhat entrenched. It has given up some ground in the last seven months, but still stood at 6% in February, well above the 2% target. Furthermore, core inflation (5.5%) remains very high as well.
The Fed already eased the pace of rate hikes at its last meeting in early February, when it greenlighted a 0.25 percent increase after four consecutive increases of 0.75 and a subsequent one of 0.50. The central bank warned at the time that additional increases would be required, and investors believed there would be a similar increase in March. However, after the spectacular job figures from January and signs that demand was not cooling off, Powell appeared before Congress and warned that rate hikes could pick up speed again.
In less than a year, official interest rates have risen from close to 0% to the 4.5-4.75% range, their highest level since 2007. This is the sharpest increase in the price of money since the early 1980s. That rise in rates has detracted from the value of long-term Treasury bonds that financial institutions have in their portfolios. Those losses, in turn, acted as a trigger for Silicon Valley Bank’s crisis (along with various mistakes and blunders made by the bank). Other banks collectively hold hundreds of billions in unrealized losses.
The fall of Silicon Valley Bank and ensuing financial instability have led some analysts to speculate about the possibility of a pause in rate hikes. In the midst of a storm, Goldman Sachs was considering this pause “in light of the recent tensions in the banking system.”
Most analysts, however, expect a rise of 0.25 percent, following the same script as the Bank of England and the European Central Bank (ECB): rate hikes to combat inflation, liquidity measures to ease financial tensions. The Fed has already provided additional liquidity, but some analysts expect additional measures this Wednesday.
“We expect the Fed to hike by 25 basis points at this meeting, but the decision and outlook for any tightening depend on financial stability. Recent economic momentum and inflation have been overshadowed by banking system risks, sharply repricing the Fed’s path,” said analysts at Bank of America, who believe the outlook for monetary policy includes a terminal target range of 5.25-5.5%, and a mild recession in the U.S. beginning from the third quarter of 2023.
Oxford Economics is also betting on a rise: “The Fed has signaled that it is not going to risk that high inflation lingers for longer than anticipated or that the dreaded wage-price spiral occurs, which is why we expect the FOMC [Federal Open Market Committee] will continue to hike this week. However, some Fed officials will likely argue for a pause. If the Fed opted to pause this week, it would pose a significant communication challenge.” Powell has stressed that he does not want to repeat the mistakes of the late 1970s and early 1980s, when the central bank paused but later needed to resume raising.
There’s a saying on Wall Street that the Fed raises rates until it breaks something. Previous cycles of rising official rates led to the subprime mortgage crisis of 2007, and before that, the collapse of the LGTM fund in 1998 and the devaluation of the Mexican peso in 1994. Compared with those episodes, the current financial storm seems like a minor hiccup. In all those earlier cases, moreover, inflation was not as much of an issue as it is now.
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