The US Federal Reserve must make one of the most consequential decisions of its rate-raising campaign this week as it considers whether to implement another increase without knowing if efforts to shore up the banking sector will work in the long term.
Central bank officials will gather on Tuesday for their latest two-day meeting, at which they must decide whether to press ahead with another quarter-point rate rise or forgo an increase.
The dilemma comes as global authorities have acted swiftly to support the financial system in the wake of Silicon Valley Bank’s collapse, with the Fed rolling out a new facility to aid lenders and the Swiss government brokering a hasty takeover of a faltering Credit Suisse by UBS.
However, it remains unclear whether these actions will be enough to stem the fallout from the crisis. The share prices of most regional US banks are languishing well below the levels seen before the implosion of SVB, while First Republic Bank’s stock is still plummeting following a second downgrade of its credit rating on Sunday.
As a result, the Fed is to some extent flying blind as it decides whether to pause its aggressive campaign to curb persistent inflation in an effort to help stabilise the financial system.
“It’s a tremendously challenging time,” said Ellen Meade, who served as a senior adviser to the central bank’s board of governors until 2021. “In this case, [Fed chair Jay] Powell has to be both a firefighter and a policeman.”
Further complicating the high-stakes decision, due on Wednesday, is that it will be accompanied by fresh projections not just for the trajectory of interest rates, but also for growth, inflation and unemployment, at a time when the economic situation is changing rapidly.
“This whole thing is a disinflationary event . . . but it’s very difficult to know at this point how disinflationary it is,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics, referring to the turmoil in banking.
Fuelling the uncertainty is the fact that regional banks are expected to sharply curtail their lending in response to the recent ructions. Torsten Slok, chief economist at Apollo Global Management, estimates that banks holding roughly 40 per cent of all assets across the sector could retrench, which would lead to a sharp recession this year.
“What we do know is that the combination of both the lagged effects of monetary policy slowing things down and now magnifying that with this downside risk is just making things more complicated,” he said.
Slok estimates the combination of tighter financial conditions and lending standards following the recent bank failures has in effect raised the federal funds rate — the rate at which banks lend to each other — by 1.5 percentage points from its current target range of between 4.5 per cent and 4.75 per cent.
As a result, he now expects the Fed to forgo a rate rise on Wednesday. Economists at Goldman Sachs, who also project a pause this week, forecast the equivalent of roughly a quarter-point to a half-point increase in the fed funds rate following recent events. Other economists argue it is still too early to make a precise estimate.
Pausing the rate-rising campaign altogether would mark an abrupt U-turn for the central bank, which had as recently as this month raised the prospect of accelerating the pace of rate rises with a half-point increase after last month shifting down to a more typical quarter-point cadence.
In congressional testimonies before the release of February’s jobs and inflation figures, Powell said the decision would hinge in part on those closely watched pieces of data, neither of which showed much sign of a cooling economy. He also said the Fed would ultimately need to lift its benchmark rate higher than the 5.1 per cent projected by officials as recently as December.
Most economists have since revised down their expectations for the so-called dot plot, which aggregates individual forecasts for the fed funds rate through to 2025.
Before the implosion of SVB, many thought the median estimate for the so-called terminal rate would rise by half a percentage point to between 5.5 per cent and 5.75 per cent. Now, some forecast that to remain unchanged while others expect only a quarter-point increase.
Traders in fed funds futures markets are even more hesitant, suggesting the Fed will only raise rates another quarter of a percentage point before reversing course and implementing cuts.
“The Fed has got some more to do,” said Vincent Reinhart, who worked at the US central bank for more than two decades and is now at Dreyfus and Mellon, though he said officials were “less sure where they’re headed”.
Banks in turmoil
The global banking system has been rocked by the collapse of Silicon Valley Bank and Signature Bank and the last-minute rescue of Credit Suisse by UBS. Check out the latest analysis and commentary here
Economists polled in the latest Financial Times survey, conducted in partnership with the Initiative on Global Markets at the University of Chicago’s Booth School of Business, said recent events had led them to scale back their expectations for the fed funds rate at the end of the year by a quarter of a percentage point. However most still see the Fed raising the rate at least to 5.5 per cent — and keeping it there until 2024.
Reinhart warned that if the Fed were to pause its rate rises in an attempt to shore up financial stability, especially as further tightening is warranted by the economic data, it would face increased criticism for having failed to manage the banking sector sufficiently to prevent such a problem in the first place.
Moreover, Meade cautioned that such a move could call into question Powell’s commitment to fighting inflation, adding she supported a quarter-point rise.
“It preserves the notion of credibility that he’s gone to great lengths to restore over the past year,” she said. “I wouldn’t think he would want to let that go at this point.”
