The banking meltdown put the Fed in a bind
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With just a few days to go until the Federal Reserve’s next interest rate decision, US policymakers are sitting between a rock and a hard place.
The recent banking sector meltdown, triggered partially by Silicon Valley Bank crumbling under the weight of higher interest rates, has led some economists and analysts to call for a moratorium on rate hikes until the industry sorts itself out.
At the same time, inflation remains well above the central bank’s goal of 2%, economic data continues to show labor market strength and consumer spending resilience, and Fed officials have signaled their intent to tighten monetary policy aggressively until price hikes ease.
“The elevated inflation backdrop means that [the Fed] is in a very delicate situation compared with the past 40 years,” wrote Gregory Daco, chief economist at EY, in a note Thursday. In prior years, the Fed was able to respond “unswervingly” to financial risks by loosening policy without worrying about price stability, he said. But conditions today are “very different with inflation still too high.”
So what should policymakers do at their March 21-22 meeting?
The reputation play: The question isn’t about what the Fed should do, it’s about what the Fed will do, said Daco. “And legacy may be the defining factor,” he added. “[Federal Reserve Chair Jerome Powell] and most policymakers do not want their legacy to be a failure to bring inflation down to the 2% target.”
That was the view the European Central Bank took on Thursday when President Christine Lagarde announced an aggressive half-point interest rate hike just hours after Credit Suisse accepted a $53.7 billion loan to help stay afloat.
Lagarde opted to portray that rate increase as a signal that the financial system remains strong. The central bank has the tools if needed to respond to a liquidity crisis “but this is not what we are seeing,” she told reporters on Thursday.
Lagarde stressed that European banks are much more resilient than they were before the global financial crisis, with strong capital and liquidity positions, and no concentration of exposure to Credit Suisse.
Most large banks have some level of financial connection or relationship with other banks, either, because they have lent money to those banks, invested in them, or have other financial agreements in place. But in the case of Credit Suisse, which has been a slow-moving car wreck for years, many large institutions have already distanced themselves.
The ECB’s stance opens the door to larger hikes from the Fed next week.
“The implications [of the ECB hike on] the Fed’s meeting next week suggests that the Fed will raise rates [a quarter point] based on futures probability, but will make it clear that the stability of the banking system remains strong,” said Quincy Krosby, chief global strategist at LPL Financial.
The dual-track approach: The Fed will likely borrow another tactic from the ECB: To carefully distinguish its inflation-fighting campaign from its work to contain financial system woes.
By implementing this dual-track approach, “the Fed would be able to continue tightening monetary policy gradually while closely monitoring financial market developments,” said Daco.
Under this plan, Powell would use his press conference on Wednesday to emphasize the separation between monetary policy and the Fed’s work to mitigate the risk of cascading failures in the financial world.
The predictions: The majority of investors are betting that the Fed will hike rates by a quarter point next week, though a significant minority are pricing in a pause in hikes, according to the CME FedWatch tool. Prior to the current stress in the banking sector, Fed officials were hinting that they would hike rates by half a point. Investors now think there’s a 0% chance of that happening.
But Wall Street might be due for a surprise on Wednesday, say some economists.
“Markets have slashed their expectations of interest rate paths, expecting central banks to come to the economy’s rescue by cutting rates as they used to do in episodes of financial stress,” wrote BlackRock analysts on Thursday. “We think that’s misguided and expect major central banks to keep hiking rates in their meetings in coming days to try to rein in persistent inflation.”
Same as it ever was: While jarring, the situation Powell now faces is not unprecedented, said Seema Shah, chief global strategist at Principal Asset Management.
“Every central bank tightening cycle in history has induced some sort of financial strains,” she wrote Thursday. “Until this week, markets had broadly ignored the threats that tightening policy was starting to uncover. The latest turmoil, however, has quickly reminded investors that risk assets simply cannot escape the wrath of monetary tightening.”
Eleven of the largest banks in the US have extended a $30 billion lifeline to First Republic Bank in an effort to save the regional lender from the fate of its industry peers, Silicon Valley Bank and Signature Bank.
Shares of the First Republic had plunged in the aftermath of SVB’s collapse last week and reports began to circulate that the bank was exploring a possible sale. On Thursday, the group of financial titans announced that they would infuse the bank with enough money to meet withdrawal demand and to hopefully restore some confidence in the security of the US banking system.
“This show of support by a group of large banks is most welcome, and demonstrates the resilience of the banking system,” the Treasury Department said in a statement Thursday.
The major banks include JPMorgan Chase, Bank of America, Wells Fargo, Citigroup and Truist.
In a statement, the banks said their action “reflects their confidence in First Republic and in banks of all sizes,” adding that “regional, midsize and small banks are critical to the health and functioning of our financial system.”
Speaking of lifelines, beleaguered megabank Credit Suisse may need more help to stay afloat, reports CNN’s Mark Thompson.
JP Morgan’s banking analysts said the $53.7 billion support offered by the Swiss central bank would not be sufficient, given “ongoing market confidence issues” with Credit Suisse’s plan to carve out its investment bank, and the erosion of the wider business.
Customers withdrew 123 billion Swiss francs ($133 billion) from Credit Suisse in 2022 — mostly in the fourth quarter — and the bank reported in February an annual net loss of nearly 7.3 billion Swiss francs ($7.9 billion), its biggest since the global financial crisis in 2008.
“In our view, status quo is no longer an option as counterparty concerns are starting to emerge as reflected by credit/equity markets weakness,” the JP Morgan analysts wrote in a research note Thursday, adding that a takeover — probably by bigger Swiss rival UBS (UBS) — was the most likely endgame.