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The Federal Reserve bows to banking crisis fears with a quarter-point rate hike, putting the fight against inflation on hold for a bit


The Federal Reserve raised interest rates by a quarter point on March 22, 2023, bowing to market expectations that it would temper its aggressive program of rate hikes amid an ongoing banking crisis.

The US central bank raised interest rates to a range of 4.75% to 5%, the ninth increase in a row since March 2022. Even in early March 2023, it appeared that the Fed was planning to resume last year’s campaign at full throttle, after a delay in February. But the collapse of Silicon Valley Bank on March 10 forced the central bank to step back.

So what does the Fed’s announcement tell us about where monetary policymakers think the economy – and inflation – is headed? A team of economists and financial scientists have helped to make sense of it all.

Rate hike shows Fed confidence in banking sector

Jeffery S. Bredthauer, University of Nebraska, Omaha

This moderate rate hike indicates that the Fed is cautious about stabilizing the financial sector, which has struggled since the collapse of the Silicon Valley Bank on March 10, 2023. But the fact that the Fed raised rates in the first place recognizes that the fight against inflation must continue.

While it’s still an increase, I think it’s more of a pause because until the recent banking turmoil, the central bank would raise interest rates by half a point. Inflation has remained stubbornly high even though the Fed had raised rates by 4.5 percentage points before the latest hike, and Chairman Jerome Powell made it clear in congressional testimony that he intended to temper the rise in prices.

But aggressive interest rate hikes left some regional banks, such as Silicon Valley Bank, vulnerable as they drove the value down of tens of billions in assets they held. Silicon Valley failed because it didn’t have enough assets to cover withdrawals.

SVB, the proverbial stick in the spokes of Fed plans.
Patrick T. Fallon/AFP via Getty Images

While the Fed and other regulators acted to get ashore the system by holding back savers and smaller financial institutions, the concern now is that more banks may be in a similar situation. The smaller rate hike should allay some of these concerns.

Still, the inflation battle must continue, and the Fed recognizes that strong demand continues consumer prices, particularly in the services sector. As such, I believe the Fed news shows it has confidence in the banking system by continuing rate hikes, albeit at a slower pace than previously expected.

And this is important. The biggest fear would be that frightened customers will irrationally withdraw money from banks because they fear a financial collapse – the classic bank run. That is not going to happen as long as there is confidence in the banking system.

Drop in inflation gave Fed breathing space to ‘pause’

Joerg Bibow and Marketa Wolfe, Skidmore College

The Fed had two options for setting interest rates. The former would have seen it continue to raise interest rates aggressively, ignoring financial stability concerns – perhaps even seeing the hiking campaign as some kind of blood-letting that would squeeze inflation out of the economy. The second way forward would be to take a beat and see how the continued vulnerability in the banking sector takes place first.

Fortunately, in our view, the Fed has not chosen the former.

While falling short of a total pause in raising interest rates – an option that some market watchers had been asking for – the latest rate hike represents a significant delay from the Fed’s previous plans, and therefore demonstrates the Fed’s caution in the face of a nascent banking situation.

It was able to do this largely because there are clear signs that inflation has fallen.

As measured by the Personal consumption Expenditure Price index – the The Fed’s preferred measure – inflation has fallen from a 40-year high of 7% in June 2022 to 5.4% in January 2023.

And the main cause of the recent rise in inflation – Supply chain disruptions from COVID-19 – have decreased. Moreover, there has been no upward wage-price spiral.

Moreover, the banking turmoil may have already led to a equivalent to a new rate hike in terms of impact on the economy.

While inflation remains high by historical standards, the risk of it accelerating again appears low. All in all, this allowed the Fed to take a breather and deal with what is going on in the banking sector.

Put another way, with so much uncertainty about the impact of the recent turmoil on the economy, the Fed decided that the risk of doing more damage outweighed the risk of inflation.

Interest rates could spike soon

Arabinda Basistha, West Virginia University

A big question among Fed watchers has been when will the central bank stop raising interest rates or when will it set a “final rate” – that is, the level that monetary policymakers believe will keep prices stable.

That point may be just around the corner.

September 2022, Powell said the Fed tried to “reach a point where real interest rates are positive across the entire yield curve”.

The real interest rate is a measure of the real inflation-adjusted cost of borrowing, which is calculated by subtracting expected inflation from the nominal interest rate. A yield curve shows yields for bonds with different maturities.

In September, part of the yield curve was negative, meaning annual inflation was higher than interest rates. Today, more of the bend has turned positive, meaning the Fed is closer to Powell’s target.

In addition, Powell switched from declare that “continued” rate hikes “will” be necessary for the softer ones some additional “increases” may be appropriate”, suggesting that it sees the light at the end of the interest rate tunnel. Powell also acknowledged that the stress in the banking sector can act in a manner similar to a rate hike by easing inflationary pressures through lower business activity.

All in all, it looks like the Fed is much closer to its policy target with one or two more moderate rate hikes this year, if inflation risks move in line with expectations. I see a pause in interest rates as early as the fall when they are settled with a terminal rate of about 5.5%.

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