The Federal Reserve must choose between inflation and market chaos

“Our policies work through financial conditions,” said Federal Reserve Chairman Jerome Powell late last year, referring to the monetary policy causal chain. As interest rates rise, tighter financial conditions cause businesses and consumers to cut spending, resulting in a slowing economy and lower inflation. The past ten days have revealed a less than desirable causal chain: from higher rates to a banking crisis.

These stormy financial conditions present the Fed with a dilemma. Should it continue to focus on high inflation and therefore keep raising interest rates? Or is financial stability priority now?

On March 22, policymakers will decide at a regular monetary policy meeting. Before the turmoil that began with a run on the Silicon Valley bench, a ninth straight rate hike seemed a foregone conclusion. The debate was whether the Fed would opt for a quarter-point hike like in January or a half-point hike. Now there is uncertainty as to whether interest rates will be raised at all. Market prices assign about a 60% chance of a quarter-point hike and a 40% chance of the Fed continuing – not far from a coin toss.

The argument for a pause relies on two arguments. First, higher interest rates are at the root of financial chaos. While Silicon Valley Bank was an outlier with its missteps, other banks and financial firms, from hedge funds to insurers, have large mark-to-market losses on their bond holdings. A further rise in interest rates could add to their notional losses.

Second, instability itself is a drag on the economy. When trust breaks, companies seek capital. Banks are lending less and investors are withdrawing. Financial conditions – which include interest rates, credit spreads and stock values ​​- have tightened sharply over the past 10 days. Eric Rosengren, a former president of the Fed’s Boston branch, has compared it to the aftermath of an earthquake. Before normal life resumes, it is advisable to check if there are aftershocks and if the buildings are structurally sound. A similar logic applies to monetary policy after a financial shock. “Go slow, look for other problems,” warned Mr. Rosengren.

Proponents of pushing a rate hike accept that financial instability is a form of tightening. But they see this as an argument for a quarter-point rise instead of the half-point that many favor. Sticking with a rate hike now would signal that the Fed is still looking to dampen inflation, which remains too high to be uncomfortable, such as the 6% yoy rise in consumer prices in February shows. The flicker of a recovery in the housing sector suggests that much of the economy can withstand higher interest rates, in contrast to poorly run banks.

A rate hike would also show that the Fed can chew gum and walk at the same time. In an ideal world, officials should be able to manage financial stability while keeping inflation under control. With a combination of deposit insurance, a new liquidity facility and support from larger banks, a framework is now in place to support US financial institutions.

The extent of support is indicated by the size of the expansion in the Fed’s balance sheet. In the week ended March 15, banks borrowed nearly $153 billion from the Fed’s discount window, up from less than $5 billion the previous week, as well as another $11.9 billion from the central bank’s new liquidity facility. This has mitigated the sell-off in markets, at least for now, which may give the Fed room to turn its attention back to inflation. In fact, it can take a cue from the example of the European Central Bank, which on March 16 announced a half-point rate hike despite the financial chaos.

Then there is the question of market psychology – all the more important in times of panic. Contrary to intuition, a rate hike can be somewhat reassuring. A pause would suggest that the Fed, which has been hawkish in tone and action for the past year, is genuinely concerned. A rise, on the other hand, would signal that it believes the crisis is under control.

Numerically, the difference between the options is small. The Fed is expected to either leave its short-term interest rate target in a range between 4.5% and 4.75% or raise it to 4.75% and 5%. From a purely financial point of view, this is almost irrelevant. Politically, it could hardly be more important.

© 2023 The Economist Newspaper Limited. All rights reserved.

From The Economist, published under license. For the original content see

Source :

Leave a Reply

Your email address will not be published. Required fields are marked *