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Jeanna Smialek: Federal Reserve’s Path Is Murkier After Bank Blowup



The Federal Reserve has been rapidly raising interest rates to fight inflation. But making big moves could be trickier amid instability. The Federal Reserve's hotly-anticipated March 22 interest rate decision is just a week and a half away, and the drama that swept the banking and financial sector over the weekend is drastically shaking up expectations for what the central bank will deliver.

The Fed had been raising interest rates rapidly to try to contain the most painful burst of inflation since the 1980s, lifting rates to above 4.5 percent from near zero a year ago. Concern about rapid inflation prompted the Fed to make four consecutive three-quarter point increases last year before slowing to a half point in December and a quarter point in February.

Before this weekend, investors had seen a substantial chance that the Fed would make a half point increase at its meeting next week. That step up was seen as an option because job growth and consumer spending have proven surprisingly resilient to higher rates – prompting Jerome H. Powell, the Fed chair, to signal just last week that the Fed would consider a bigger move.

But investors and economists no longer see that as a likely possibility.

Three notable banks have failed in the past week alone as Fed interest rate increases ricochet through the technology sector, cryptocurrency markets and upend even usually staid bank business models.

Regulators on Sunday evening unveiled a sweeping intervention to try to prevent panic from coursing across the broader financial system, with the Treasury, Federal Deposit Insurance Corporation and Fed said that depositors at the failed banks would be paid back in full. The Fed announced a dramatic emergency lending program that will help to funnel cash to banks who are facing steep losses on their holdings because of the change in interest rates.

The tumult – and the risks to higher interest rates that it exposed – is likely to make the central bank more cautious as it pushes forward.

Investors have abruptly downgraded how many interest rate moves they expect this year. After Mr. Powell's speech last week opened the door to a large rate change at the next meeting, investors had sharply marked up their 2023 forecasts, even penciling in a tiny chance that rates would rise above 6 percent this year. But after the wild weekend in finance, they see just a small move this month and expect the Fed to cut rates to just above 4.25 percent by the end of the year.

Economists at J.P. Morgan said that the situation bolsters the case for a smaller quarter-point move this month.

"I don't hold that view with tons of confidence," said Michael Feroli, chief U.S. economist at J.P. Morgan, explaining that it was conditional on the banking system functioning smoothly. "We'll see if these backstops have been enough to quell concerns – if they are successful, I think the Fed wants to continue on the path to tightening policy."

Goldman Sachs economists no longer expect a rate move at all. While Goldman analysts still think the Fed will raise rates to above 5.25 percent, they wrote on Sunday evening that they "see considerable uncertainty about the path."

This moment poses a major challenge for the Fed: It is in charge of fostering stable inflation, which is why it has been raising interest rates to slow spending and business expansions, hoping to rein in growth and cool price increases. But it is also tasked with maintaining financial system stability.

Because higher interest rates can unveil weaknesses in the financial system – as the blowup of Silicon Valley Bank on Friday and the towering risks facing the rest of the banking sector illustrated – those goals can come into conflict.

Subadra Rajappa, head of U.S. rates strategy at Societe Generale, said on Sunday afternoon that she thought the unfolding banking situation would be a caution against moving rates quickly and drastically – and she said instability in the banking sector would make the central bank's job "trickier," forcing it to balance the two jobs.

"On the one hand, they are going to have to raise rates: That's the only tool they have at their disposal," she said. On the other, "it's going to expose the frailty of the system."

Ms. Rajappa likened it to the old saying about the beach at low tide: "You're going to see, when the tide runs out, who has been swimming naked."

Some saw the Fed's new lending program – which will allow banks that are suffering in the high rate environment to temporarily move a chunk of the risk they are facing from higher interest rates to the Fed – as a sort of insurance policy that could allow the central bank to continue raising rates without causing further ruptures.

"The Fed has basically just written insurance on interest rate risk for the whole banking system," said Steven Kelly, senior research associate at Yale's program on financial stability. "They've basically underwritten the banking system, and that gives them more room to tighten monetary policy."

Jeanna Smialek writes about the Federal Reserve and the economy for The Times. She previously covered economics at Bloomberg News.  @jeannasmialek


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Posted: March 13, 2023 Monday 08:54 AM