Fed Meets as Bank Chaos Collides With Inflation

Fed Meets as Bank Chaos Collides With Inflation

The Federal Reserve entered 2023 focused on one key goal: fighting the rapid inflation that has been plaguing American consumers since 2021. But in the last two weeks this task has become much more complicated.

Many economists expect central bankers to hike interest rates by a quarter point to just over 4.75 percent on Wednesday and continue their fight against rapid price increases. A number of investors and analysts had been expecting the Fed to make an even bigger rate move until a series of high-profile bank closures and government bailouts raised concerns about the economic outlook and financial stability.

On Sunday, the Fed pumped up its program that maintains dollar funding around the world, its second move in a week to prop up the financial system. Last Sunday, she presented an emergency loan program intended to act as a relief valve for banks that need to raise cash.

Jerome H. Powell, the Fed Chair, and his colleagues must now decide how to respond to the banking turmoil when it comes to interest rate policy, which sets the pace of the economy. And they must do so quickly. In addition to announcing a rate decision this week, Fed officials will also release a series of quarterly economic forecasts detailing how much they expect borrowing costs to rise this year. Central bankers had expected to raise it to around 5 percent in 2023 and ahead of market volatility indicated they might adjust this expected peak even higher in their new projections.

But now, against the backdrop of banking system instability, Fed officials must take their next step. They could try to balance the risk of prolonged inflation against the risk of financial turmoil — by raising rates more slowly and stopping earlier to avoid further turmoil. Or they could try to separate their inflation fight entirely from the issue of financial stability. In this scenario, when setting interest rates, the Fed would only consider banking problems to the extent that they were likely to slow down the real economy.

That’s the approach taken by the European Central Bank last week as it rolled out plans to hike interest rates by half a point, despite being dragged into the market chaos by one of Europe’s largest banks, Credit Suisse.

The range of possibilities makes this the most uncertain central bank meeting in years: during Mr Powell’s tenure, officials have mostly hinted at what they will do with interest rates ahead of their meeting, lest they surprise financial markets with their policy adjustment, provoking a reaction that is larger than is justified. But earlier this week there is little clarity. Investors were putting 60 percent odds on a quarter-point hike and 40 percent odds on no movement at all.

Frequently asked questions about inflation

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What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar won’t go as far tomorrow as it did today. It is usually expressed as the annual change in the price of essential goods and services such as food, furniture, clothing, transportation and toys.

What Causes Inflation? This may be the result of increasing consumer demand. However, inflation can also rise and fall on developments that have little to do with economic conditions, such as E.g. limited oil production and problems in the supply chain.

Is inflation bad? It depends on the circumstances. Rapid price increases mean problems, but moderate price increases can lead to higher wages and job growth.

Can inflation affect the stock market? Rapid inflation usually spells trouble for stocks. Financial assets in general have historically performed poorly during inflationary booms, while tangible assets like houses have held up better.

Some Wall Street economists thought the Fed would pause, and at least one or two expected an outright rate cut in response to the shake-up, though many expected a quarter-point hike.

“You lose time in the fight against inflation by waiting,” said Michael Feroli, chief US economist at JP Morgan. Still, Mr. Feroli had expected the Fed to raise its forecast of how high it would raise interest rates this year, and he now expects it to leave its peak interest rate estimate unchanged at around 5 percent.

The banking turmoil is likely to weigh on the economy, meaning the central bank itself doesn’t have to do as much to curb economic growth. Torsten Slok, chief economist at Apollo, estimated that last week’s tightening of lending standards and other effects was roughly equivalent to a 1.5 percentage point hike in the Fed’s interest rate.

“In other words, monetary conditions have tightened over the past week to the extent that the risks of a deeper slowdown in the economy have increased,” Mr Slok wrote in an analysis over the weekend.

However, it is unclear how long a decline in banks’ willingness to lend will last or stabilize or worsen. Amid the great uncertainty, Diane Swonk, the chief economist at KPMG, said officials could potentially scrap their economic forecasts altogether, as they did at the start of the coronavirus pandemic.

Their release would “create more confusion than clarity as we just don’t know,” Ms Swonk said.

Mr. Powell is set to hold a press conference Wednesday following the release of the Fed’s post-meeting statement, which could be tense for a number of reasons: Mr. Powell will most likely face questions about what went wrong with Silicon Valley oversight is bench. The Fed was its primary regulator and was aware of the bank’s problems for more than a year prior to its collapse.

And Mr. Powell will have to explain how officials are pondering their policy path at a complicated juncture when the Fed must balance economic momentum against explosions in the banking sector.

New hires have remained very strong in recent months, with employers adding more than 300,000 jobs in February, up from more than half a million in January. Officials had expected hiring to slow significantly from nearly zero last March, the fastest pace of adjustment since the 1980s, after a year when rapid rate hikes pushed borrowing costs above 4.5 percent in February.

Inflation has also shown unexpected stickiness. While the consumer price index has been slowing for months year-on-year, it remained unusually high at 6 percent in February. And a closely watched monthly consumer price measurement, which excludes groceries and fuel, which are price-jumping, bounced back.

Barclays economists suggested that the incoming data would likely have prompted the Fed to opt for a larger half-point rate hike, all else being equal. But given the ongoing banking woes — and the fact that Silicon Valley Bank’s plight is partly related to higher interest rates — they expected the Fed to drop a quarter-point at this meeting to avoid further bank uncertainty.

“The link between rising interest rates and the risk of another banking crisis presents clear tension for the F.OM.C,” wrote economist Marc Giannoni and colleagues, citing the Fed’s Monetary FOMC. “Risk management considerations will justify a less aggressive monetary policy hike in March.”

The economists noted that if the situation in the US banking system were not so closely linked to rising interest rates, Fed officials would most likely prefer to separate concerns about financial stability from their fight against inflation.

That’s essentially what the European Central Bank decided last week. Officials there are also battling rapid inflation and stand behind the Fed in raising rates after they started later. Their decision to hike rates by half a point even came as Credit Suisse was struggling to survive, prompting the Swiss government to arrange a sale of the bank to UBS on Sunday.

“This will not stop our fight against inflation,” Christine Lagarde, the President of the European Central Bank, told a March 16 news conference on price stability and financial stability, and that central bankers had separate tools to achieve both.

That kind of message could be one the Fed wants to emulate, said JP Morgan’s Mr. Feroli. Still, there are key differences in the United States, where outright bank failures occurred and where Fed interest rate moves were part of the stress that caused the turmoil.

KPMG’s Ms Swonk said she didn’t think the ECB’s actions would serve as a roadmap for the Fed “given that the path is changing as we speak” and that she expected policymakers to hold back such a rate hike week.

“At this point, a meaningful pause is warranted for the Fed,” she said. “It’s a marathon, not a sprint – back off now and promise to do more later if needed.”

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2023-03-20 09:00:11