“ohyour policy Actions work through financials. ’” Fed Chairman Jerome Powell said late last year about the causal chain of monetary policy. Tighter financial conditions as interest rates rise lead companies and consumers to cut back on spending, leading to an economic slowdown and inflation The decline.The past ten days illustrate a less than ideal causal chain: from higher interest rates to a banking crisis.
These stormy financial conditions present a dilemma for the Fed. Should it continue to focus on high inflation and thus continue to raise interest rates? Or is financial stability the priority now?
On March 22, at a regular monetary policy meeting, policymakers will make a decision. A ninth straight rate hike seemed a foregone conclusion ahead of the turmoil that began with a run on banks in Silicon Valley. At issue is whether the Fed will choose to raise rates by 25 basis points, as it did in January, or 0.5 basis points. Now there is uncertainty about whether it will raise rates. The market is pricing in roughly a 60% probability of a 25 basis point rate hike and a 40% probability of the Fed remaining unchanged – not far from a coin toss.
The reason for the suspension is based on two arguments. First, higher interest rates are a source of financial chaos. Even if SVB was an exception to its blunders, other banks and financial firms, from hedge funds to insurance companies, have suffered huge losses by market value on their bond holdings. Further increases in interest rates could increase their notional losses.
Second, instability itself is a drag on the economy. As confidence crumbles, companies try to preserve capital. Banks are lending less and investors are pulling their money. Indicators of financial conditions – including interest rates, credit spreads and equity values - have tightened sharply over the past ten days. Former Federal Reserve Bank of Boston president Eric Rosengren likened it to the aftermath of an earthquake. Before returning to normal life, it is prudent to check for aftershocks and the structural integrity of buildings. Similar logic applies to monetary policy after a financial shock. “Take your time and check for other problems,” Mr. Rosengren warned.
Proponents of rate hikes acknowledge that financial instability is a form of austerity. But they saw that as an argument in favor of a 25-basis-point hike, rather than the 50-basis-point hike many favored. Insisting on rate hikes now would signal that the Fed still intends to curb inflation, which remains uncomfortably high, as evidenced by a 6% year-on-year rise in consumer prices in February. Signs of recovery in the housing sector suggest that, unlike ailing banks, much of the economy can afford higher interest rates.
The rate hike also shows that the Fed can walk while chewing gum. In an ideal world, officials should be able to manage financial stability while controlling inflation. Combining deposit guarantees, a new liquidity facility, and support from large banks, the framework to support U.S. financial institutions is now in place.
The size of the Fed’s balance sheet expansion reveals the scale of support. Banks borrowed nearly $153 billion from the Fed’s discount window in the week ended March 15, up from just under $5 billion the previous week, and borrowed another $11.9 billion from the central bank’s new liquidity facility. That eased the market sell-off, at least for now, which could give the Fed room to turn its attention back to inflation. Indeed, it can look to the example of the European Central Bank, which announced a half-basis-point rate hike on March 16 despite the financial chaos.
Then there’s the psychology of the market — especially in times of panic. Counterintuitively, a rate hike might be somewhat reassuring. The pause shows that the Fed, as hawkish as it has been in its tone and actions over the past year, is really concerned. An increase, by contrast, would signal that it believes the crisis is under control.
Numerically, the differences between the options are small. The Fed is expected to either keep its short-term interest rate target between 4.5% and 4.75%, or raise it to a range between 4.75% and 5%. From a purely financial standpoint, it’s pretty much irrelevant. In terms of policy, it couldn’t be more important. ■
