Federal Reserve ‘between rock and hard place’ pending interest rate decision

This week, Federal Reserve officials will gather for one of the most uncertain central bank policy meetings in years.

Forced to balance the effects of the banking crisis and inflation that remains well above its target, the Fed is expected to raise interest rates by another 0.25% following the release of its latest policy decision at 2:00 pm ET Wednesday afternoon. The move would raise the Fed’s benchmark interest rate to 4.75%-5%, the highest level since 2006. Fed Chairman Jerome Powell will hold a press conference at 2:30 pm ET to explain the Fed’s decision.

“They are between a rock and a hard place,” said Wilmer Stith, bond portfolio manager at the Wilmington Trust. “There’s a banking crisis going on and it’s really a very precarious, uncomfortable position for the Fed.”

During his semi-annual speech to Congress in early March, Fed Chairman Jerome Powell said strong economic data is likely to push interest “higher than previously expected.”

Just days later, the 16th largest bank in the US, Silicon Valley Bank, was taken over by the FDIC, the second-biggest bank failure in US history. By the evening of Sunday, March 12, the Fed, Treasury and FDIC stepped in to support deposits in the bank and, in fact, deposits in the banking system.

Regulators also seized Signature Bank on March 12, and last week the banking industry effectively staged a bailout for troubled lender First Republic. Shares of First Republic hit a record low on Monday as investors fear the bank will become the fourth US bank to fail this month.

WASHINGTON, DC - MARCH 8: Federal Reserve Chairman Jerome Powell testifies before the House Financial Services Committee on Capitol Hill March 8, 2023 in Washington, DC.  During the hearing, Powell answered questions on a range of topics related to the Federal Reserve's semi-annual report on monetary policy and the state of the economy.  (Photo by Anna Moneymaker/Getty Images)

Federal Reserve Chairman Jerome Powell testifies before the House Financial Services Committee on Capitol Hill March 8, 2023 in Washington, DC. (Photo by Anna Moneymaker/Getty Images)

Over the weekend, Swiss banking giants UBS and Credit Suisse teamed up in an emergency aimed at strengthening the European banking system. It was the Fed that issued a statement again on Sunday evening – this time on global swap lines to ensure that dollar liquidity remains plentiful around the world.

However, as of Tuesday morning, CME Group data showed that investors were 85% likely to believe the Fed would raise rates by 25 basis points on Wednesday.

“If they stop and turn around [rate hikes]it can lead markets to believe that they are not fighting inflation when inflation is still an issue, which gives you higher mortgage rates and financing costs for corporations, and even tighter restrictions on the economy,” Stith said.

After a year of fighting one problem (inflation) with one tool (higher interest rates), the Fed has had to face a whole new problem in just the last 10 days.

Don’t rule out “further trips”

In addition to announcing its latest interest rate decision, the Fed is also to release its new Economic Outlook Summary (SEP) on Wednesday, which includes officials’ projections for interest rates, inflation, unemployment and economic growth for this year’s balance sheet and the next two. , as well as long-term expectations.

“[While] Chairman Jerome Powell acknowledges the uncertainty and will underline the Fed’s readiness to adjust policy if the banking sector deteriorates, which does not necessarily mean that the new Economic Forecasts will not reflect a further increase,” Andrew said. Hunter, economist at Capital Economics.

In December, the Fed’s proposed SEP rates will peak in the 5%-5.25% range during this rate hike cycle. Powell’s testimony earlier this month suggested that the central bank should change that outlook.

On March 14, the February CPI showed that consumer prices excluding food and energy — or so-called “core” inflation — rose 0.5% month-on-month in February, representing a slight acceleration from a rise of 0.4% compared to each of the previous two months. months. On March 10, the February jobs report showed that about 311,000 jobs were created last month after more than 500,000 jobs were added to the economy in January.

This strong economic data, on which investors are betting, will force the Fed to continue raising rates, although caution is expected given the risks to financial stability in the banking sector. Ignore the banking crisis engulfing the global markets, and these inflation and job figures made a 50 basis point rate hike likely.

Or, as Powell told lawmakers on March 7, “If the data set indicated the need for faster tightening, we would be ready to increase the pace of rate hikes.”

As February turned into March, Fed officials widely circulated the idea that the 5%-5.25% peak range for the Fed funds rate would need to be revised upward.

Ahead of bank failures this month and a ten-day quiet period ahead of the Fed’s policy meeting, many Fed officials called for rates to be raised above previously forecast levels.

Fed chief Chris Waller warned in a speech on March 2 that if employment and inflation reports continue to come in hot, rates will need to rise more this year than previously expected.

Minneapolis Fed President Neil Kashkari, a voting member of the FOMC, said earlier this month that he was leaning towards raising rates higher than he had previously forecast, while Atlanta Fed President Rafael Bostic said that if the data were stronger than expected , the case can be made for higher rates

Minneapolis Fed President Neil Kashkari during an interview with Reuters in New York February 17, 2016. REUTERS/Brendan McDermid

Minneapolis Fed President Neil Kashkari during an interview with Reuters in New York February 17, 2016. REUTERS/Brendan McDermid

“It’s a toss-up,” Stith said. “They raise 25 [basis points]and stop quantitative tightening? Do they raise 25 but lower the scatter chart significantly? From my point of view, it’s less obvious now what they’re going to do 25, [and] continue to wire the medium at a higher rate. I think it’s a bar that’s too high.”

Goldman chief economist Ian Hatzius, who expects the Fed to hold its ground on Wednesday, said there is “significant uncertainty” about the path after March, but he leaves unchanged expectations for a 25 basis point hike in May, June and July. and now expects the Fed to complete its rate hike cycle with rates in the 5.25-5.5% range.

Liquidity looms

In addition to balancing full employment with stable prices, the Fed’s dual mandate has an unofficial third lever: financial stability.

This “third mandate” was the most stressed during the banking crisis this month.

The Fed has said it will use its regulatory tools to combat financial instability, and the central bank has set up an emergency lending facility to offer funding to banks to ensure banks can meet all depositor withdrawals.

This program effectively supported all deposits – both insured and uninsured – in the US financial system.

So far, banks have borrowed only about $12 billion from the program, equivalent to a fraction of the deposits that were withdrawn from Silicon Valley Bank before its collapse. However, banks borrowed $153 billion in loans through the Fed’s traditional lending program, known as the discount window, the largest amount since the 2008 financial crisis.

And as the Fed uses its tools to build confidence in the system, this effort has been a collaborative effort in Washington, DC.

Speaking before the Senate last week, Treasury Secretary Janet Yellen said she was monitoring stress in the banking system to make sure problems at Silicon Valley Bank and Signature didn’t spread to other banks.

Last Wednesday, Yellen assured Senate lawmakers that the US banking system is “robust” despite recent bank failures.

US Treasury Secretary Janet Yellen answers questions about the Biden administration's plans in the wake of the collapse of three US lenders, including Silicon Valley Bank and Signature Bank, as she testifies before the Senate Finance Committee at US President Joe Biden's proposal hearing.  Fiscal Year 2024 Budget Request, on Capitol Hill in Washington, DC, March 16, 2023 REUTERS/Mary F. Calvert

Treasury Secretary Janet Yellen answers questions about the Biden administration’s plans in the wake of the collapse of three U.S. lenders, including Silicon Valley Bank and Signature Bank, in her remarks before the Senate Finance Committee at a hearing on President Joe Biden’s proposed fiscal year 2024 budget request. Capitol Hill in Washington DC, March 16, 2023 REUTERS/Mary F. Calvert

These strains on the banking system may also contribute indirectly to some of the Fed’s goals, especially with regard to tightening financial conditions.

“The Fed wanted to tighten financial conditions and bam, they got it in a week,” Stith said.

By the end of last year, most banks were already tightening consumer and business lending standards, according to a recent poll of senior Fed loan officers.

“If credit has been tight enough to seriously affect activity, the risk is that it could eventually lead to a self-perpetuating cycle of rising unemployment, higher delinquency rates and increasingly tight credit standards,” Capital Economics’ Hunter said.

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