For the first time in recent memory, the Federal Reserve’s two-day meeting on interest rates, kicking off Tuesday, is shaping up to be a nail-biter.
Will the Fed back up its inflation-fighting rhetoric and raise interest rates again despite the aftershocks of Silicon Valley Bank’s collapse? Or will it prioritize financial stability during a period of uncertainty in the banking system?
With financial industry stress easing somewhat in recent days, most economists and investors expect the central bank to lift its key short-term rate by a quarter percentage point. That would give a nod to the recent turmoil by backing off the half-point increase markets were expecting before the crisis while adding another notch to the Fed’s aggressive rate-hiking campaign.
But, “It’s a close call,” says Kathy Bostjancic, chief economist of Nationwide Mutual.
Another rate increase would add to the Fed’s 4½ points of hikes the past year – the most in four decades. The flurry has sharply increased consumer borrowing costs for mortgages, auto loans and credit cards, and pummeled the stock market, while also lifting formerly meager rates for bank savings account.
“Fed Chair Powell and most policymakers do not want their legacy to be failure to bring inflation down to the 2% target,” Gregory Daco, chief economist of EY-Parthenon, wrote in a note to clients.
But several top economists, including Bostjancic and Goldman Sachs, figure the Fed will take the more cautious path and pause rate hikes.
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Policymakers could note the crisis itself “is going to slow economic activity and inflation,” Bostjancic says. “’We’re going to pause to assess the unique stresses’” to the financial system.
In a research note, Goldman economist David Mericle adds, “The link between a single (quarter-point) hike and the future path of inflation is quite tenuous, and the (Fed’s policymaking committee) can always hike at its next meeting just six weeks later.”
What are the Fed rate predictions?
The Fed on Wednesday is also expected to release new projections for the economy and fed funds rate. Thus, even though the central bank could hold rates steady at a range of 4.5% to 4.75%, Goldman believes officials will signal three more quarter-point rate increases by July to a range of 5.25% to 5.5%. Barclays expects the Fed to forecast a peak rate of 5% to 5.25%.
Either projection would show the Fed is still intent on boosting rates to bring down inflation and is simply standing pat for the time being out of caution. Both estimates, however, are also below the 5.5% to 5.75% peak rate that markets had predicted before SVB’s meltdown.
Now, though, markets appear to believe the crisis is worse than it seems and the Fed will bungle its rate increases, Bostjancic says. They project the Fed will hike rates Wednesday and then pause before cutting rates three times starting in July, suggesting the cocktail of banking turbulence, a slowing economy and rate hikes will set off a recession within months.
Typically, Fed officials signal their plans so as not to surprise markets but the SVB crisis emerged during a quiet period when they’re barred from communicating with the public
Here are four reasons for the Fed to raise rates by a quarter point and four reasons for it to pause.
Banking stress has eased
The crisis occurred when struggling tech companies began withdrawing their money from Silicon Valley Bank for funding needs, forcing SVB to sell bonds that had declined in value because of the Fed’s sharp rate hikes. The bank’s capital losses led additional customers whose deposits over $250,000 aren’t FDIC insured to withdraw their money.
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 purchased a teetering Credit Suisse.
The Fed and other regulators announced they would provide funding to ensure depositors at SVB, Signature and possibly other banks that pose a risk to the financial system could access all their money. They also unveiled a lending facility so other regional banks could borrow money to cover withdrawals by uninsured depositors.
Regional bank stocks tumbled last week but partly rebounded Monday. Barclays says only a handful of financial institutions are vulnerable to similar troubles because their profiles match SVB’s. In other words, many of their depositors are uninsured and large chunks of their assets are in bonds whose values have plunged.
“We now see tentative signs of stabilization,” Barclays wrote in a note to clients.
Economy, inflation have been strong
Late last year, there were signs that job and wage growth were slowing and inflation was easing. But job gains surged early this year and inflation leaped in January and February. Before the crisis, that led Powell to hint that a half-point hike was likely.
“Based on the strength of the labor market and the stubbornness on consumer inflation, it’s hard to argue it is time for the Fed to take a pause,” says Scott Anderson, chief economist of Bank of the West. “Moreover, if the Fed were to pause after their hawkish rhetoric in recent weeks, it could do even more damage to the Fed’s credibility.”
A pause could signal the Fed is worried
Regulators have taken pains to emphasize the banking system is stable.
“To pause would signal (the Fed) worries that might not be the case,” UBS says.
And that could cause depositors at other regional banks to move money to larger banks, intensifying the crisis.
The ECB raised rates sharply last week
The European Central Bank raised its key rate by a half point last week despite Credit Suisse’s troubles.
“The fact that markets did not react negatively” to the move “will also provide a measure of reassurance” to the Fed, Barclays says.
Why should the Fed pause?
The SVB crisis is doing the Fed’s work
With regional banks facing increased customer withdrawals or at least the risk of that, banks are expected to further tighten their lending standards, making it harder for consumers and businesses to get loans, Goldman says. That’s likely to hurt economic growth and soften inflation so the Fed doesn’t have to hike as much. Banks were already growing more hesitant to lend because of the increased risk of a recession this year.
Goldman Sachs says the stricter lending conditions are equivalent to a quarter- to a half-point increase in the Fed rate.
Banking turmoil has eased, not vanished
Customers have been moving money from banks to money market funds, according to a Goldman analysis of public records. Transfers from regional banks to big institutions aren’t as clear, Goldman says.
But banks took out a record $153 billion in loans from the Fed’s discount window last week, up from $4.6 billion the prior week. And the Fed’s new loan facility has lent about $12 billion. The borrowing suggests banks could be seeking funding to cover increased withdrawals or girding for that possibility.
“Overall, the size of the spike in the Fed’s emergency lending underlines that this is a very serious crisis in the banking system that will have significant knock-on effects on the real economy,” Capital Economics wrote to clients
A rate hike may intensify the stress
A rate hike could compound the conditions that led to the bank runs by further lowering the price of bonds owned by regional banks, threatening their financial health and sparking more runs.
Worse, it’s the Fed’s own aggressive hiking campaign that sparked the problem, giving Fed officials reason to be especially cautious, Bostjancic says.
Fed monetary, financial goals at cross purposes?
By hiking rates just after taking steps to alleviate banking stress, “the Fed’s monetary policy goals could be viewed as working at loggerhead with its financial stability goals,” Capital Economics said.
“We would be surprised if, just a week after going to great lengths to support financial stability, policymakers risk undermining their efforts with a rate hike,” Goldman said.