7 min read
Federal Reserve officials will convene this week for one of the central bank's most uncertain policy meetings in years.
Forced to balance the consequences of a banking crisis and inflation that remains well above target, the Fed is expected to raise interest rates by another 0.25% when it releases its latest policy decision at 2:00 p.m. ET Wednesday afternoon. This move would bring the Fed's benchmark interest rate range to 4.75%-5%, the highest since 2006. Fed Chair Jerome Powell will hold a press conference at 2:30 p.m. ET to explain the Fed's decision.
"They're in between a rock and a hard place," said Wilmer Stith, bond portfolio manager for Wilmington Trust. "There's a banking crisis and it's really a very tenuous, uncomfortable position for the Fed to be in."
During his semi-annual testimony before Congress in early March, Fed Chair Jerome Powell said strong economic data would likely push interest "higher than previously anticipated."
Just days later, the 16th-largest bank in the U.S. — Silicon Valley Bank — was taken into receivership by the FDIC, marking the second-largest bank failure in U.S. history. By the evening of Sunday, March 12, the Fed, Treasury, and FDIC had stepped in to backstop deposits at the bank and, in effect, deposits across the banking system.
Regulators also seized Signature Bank on March 12, and last week the banking industry organized a de facto bailout of troubled lender First Republic. Shares of First Republic reached a record low on Monday as investors fear the bank will be the fourth U.S. bank this month to fail.
Federal Reserve Chair Jerome Powell testifies before the House Committee on Financial Services on Capitol Hill on March 08, 2023 in Washington, DC. (Photo by Anna Moneymaker/Getty Images)
This past weekend, Swiss banking giants UBS and Credit Suisse merged in an emergency combination aimed at shoring up the European banking system. This Fed again issued a Sunday evening statement — this time on global swap lines to ensure dollar liquidity remains abundant worldwide.
Still, as of Tuesday morning, data from the CME Group showed investors placing an 85% chance on the Fed raising rates by 25 basis points on Wednesday.
"If they stop and reverse [rate hikes], that could cause markets to believe they're not fighting inflation when inflation is still a problem, giving you higher mortgage rates and funding costs for corporations and just a tighter vice on the economy," Stith said.
After a year fighting one problem (inflation) with one tool (higher interest rates), the Fed has had to firefight a whole new challenge in just the last 10 days.
Don't rule out 'further hikes to come'
In addition to announcing its latest interest rate decision, the Fed will also reveal its new Summary of Economic Projections (SEP) on Wednesday, which include officials' forecasts for interest rates, inflation, unemployment, and economic growth over the balance of this year and the next two, as well as longer-run expectations.
"[While] Chair Jerome Powell will acknowledge the uncertainty and stress the Fed's willingness to adjust policy if the situation in the banking sector worsens, that doesn't necessarily mean that the new Summary of Economic Projections won't still show further hikes to come,” said Andrew Hunter, an economist at Capital Economics.
In December, the Fed's SEP suggested rates would peak in a range of 5%-5.25% during this rate hiking cycle. Powell's testimony earlier this month suggested this outlook is what would need altering from the central bank.
On March 14, the February consumer price index showed consumer prices excluding food and energy — or so-called "core" inflation — rose 0.5% over the prior month in February, a modest acceleration from the 0.4% gain logged over each of two prior months. On March 10, the February jobs report showed some 311,000 jobs were created last month after more than 500,000 jobs were added to the economy in January.
This is the strong economic data investors are betting will force the Fed to continue raising rates, though caution is expected given financial stability risks in the banking sector. Back out the banking crisis that has enveloped global markets and these inflation and jobs numbers had made a 50 basis point rate hike likely.
Or as Powell told lawmakers on March 7: "If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes."
As February turned to March, Fed officials were widely socializing the idea that 5%-5.25% peak range for the Fed funds rate would need to be revised higher.
Leading up to this month's bank failures and before the Fed's ten-day quiet period ahead of its policy meeting, many Fed officials were calling to raise rates higher previously forecast.
Fed Governor Chris Waller warned in a speech March 2 that if jobs and inflation reports continued to come in hot rates would have to rise more than previously expected this year.
Minneapolis Fed President Neel Kashkari, a voting member of the FOMC, said earlier this month he'd lean towards pushing rates higher than he previously forecast, while Atlanta Fed President Raphael Bostic said that if data come in stronger than expected then a case could be made for higher rates
Minneapolis Fed President Neel Kashkari speaks during an interview at Reuters in New York February 17, 2016. REUTERS/Brendan McDermid
"It's a toss up," said Stith. "Do they raise 25 [basis points], but stop quantitative tightening? Do they raise 25 but lower their dot plot significantly? It's less certain now from my perspective that they're going to do the 25, [and] continue to telegraph a higher rate environment. I think that's a bar that's a little too high."
Goldman's chief economist Jan Hatzius — who expects the Fed will stand pat on Wednesday — said there is "considerable uncertainty" about the path beyond March, but he's leaving expectations unchanged for 25 basis point hikes in May, June, and July, and now expects the Fed to finish its rate-hiking cycle with rates in a range of 5.25%-5.5%.
Liquidity looms
In addition to balancing full employment with stable prices, the Fed's dual mandate has an unofficial third arm — financial stability.
This "third mandate" is what has been put under the most stress during this month's banking crisis.
The Fed has said it would use its regulatory tools to deal with financial instability, and the central bank created an emergency lending facility to offer funding to banks to ensure banks could meet all depositor withdrawals.
This program essentially backstopped all deposits — both those insured and uninsured — across the U.S. financial system.
So far banks have borrowed only about $12 billion from the program — equivalent to a small fraction of the deposits that were pulled out of Silicon Valley Bank before its collapse. Still, banks have borrowed $153 billion in loans through the Fed's traditional lending program, known as the discount window, marking the largest amount since the 2008 financial crisis.
And as the Fed uses its tools to shore up confidence in the system, these efforts have been a collaborative effort in Washington, D.C.
Speaking before the Senate last week, Treasury Secretary Janet Yellen said she is monitoring stress in the banking system to make sure problems at Silicon Valley Bank and Signature don't spread to other banks.
Yellen assured Senate lawmakers last Wednesday the U.S. banking system is "sound" despite recent bank failures.
These stresses on the banking system may also, in a roundabout way, work to accomplish some of the Fed's goals, particularly as it relates to tightening financial conditions.
"The Fed wanted to tighten financial conditions and bam, they got that in a week," Stith said.
According to the Fed's latest Senior Loan Officer Opinion Survey, most banks were already tightening standards on consumer and business loans by the end of last year.
"If credit was restricted enough to seriously hit activity, the risk is that a self-sustaining cycle of rising unemployment, higher delinquency rates and ever-tighter credit standards could eventually emerge," said Capital Economics' Hunter.
