“Our political actions work through economic conditions.” This is what Jerome Powell, chairman of the Federal Reserve, said at the end of last year, referring to the causal chain of monetary policy.
As interest rates rise, tighter financial conditions cause businesses and consumers to cut spending, leading to economic slowdown and lower inflation. The past 10 days have illustrated a less desirable causal chain: from higher interest rates to a banking crisis.
These stormy financial conditions pose a dilemma for the Fed. Should it remain focused on high inflation and thus continue to raise interest rates? Or is financial stability now the priority?
On March 22, at a regular monetary policy meeting, the politicians will take a position. Before the turmoil that started with a run on Silicon Valley Bank, a ninth straight rate hike seemed a foregone conclusion.
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The debate had been whether the Fed would choose a quarter-point hike, as in January, or a half-point hike. Now there is uncertainty as to whether it will raise interest rates at all. Market prices are assigning probabilities of about 60% to a quarter point hike and 40% to the Fed staying put – not far from a coin flip.
The justification for a break rests on two arguments. First, higher rates are the root of the financial chaos. Although Silicon Valley Bank was an outlier in its missteps, other banks and financial firms, from hedge funds to insurance companies, have large mark-to-market losses on their bond holdings. A further increase in rates could increase their theoretical losses.
Second, instability is itself a drag on the economy. As confidence crumbles, companies try to preserve capital. Banks lend less and investors withdraw. Measures of financial conditions – which include interest rates, credit spreads and share 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 resuming normal life, it is wise to see if there are any aftershocks and if buildings are structurally sound. A similar logic applies to monetary policy after a financial shock. “Go slow, look for other problems,” Rosengren warned.
Jose Luis Magana
Will the US Federal Reserve, led by Jerome Powell, continue to raise interest rates as planned?
Proponents of pushing for a rate hike accept that financial instability is a form of tightening. But they see this as an argument for a quarter-point increase instead of the half-point that many had opted for.
Going ahead with a rate hike now would signal that the Fed is still intent on taming inflation, which remains too high for comfort, as illustrated by the 6% year-over-year rise in consumer prices in February. The flickers of a recovery in the real estate industry indicate that, unlike poorly run banks, much of the economy can withstand higher interest rates.
A rate hike would also show that the Fed can chew gum and walk at the same time. In an ideal world, government officials should be able to manage financial stability while keeping inflation in check. With a combination of deposit guarantees, a new liquidity facility and support from major banks, a framework is now in place to support America’s financial institutions.
The extent of the support is revealed by the size of the expansion in the Fed’s balance sheet. In the week to March 15, banks borrowed almost $153 billion (NZD 249 billion) from the Fed’s discount window, up from less than $5 billion. USD in the previous week, as well as a further 11.9 billion USD from the central bank’s new liquidity facility.
This has eased the selloff in the markets, at least for now, which may give the Fed room to turn its attention back to inflation. Indeed, it can look to 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 salient in a time of panic. Counterintuitively, a rise in interest rates can be somewhat reassuring. A pause would suggest that the Fed, which has been hawkish in tone and action over the past year, is genuinely worried. An increase, 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 keep its target for short-term interest rates at a range between 4.5% and 4.75% or raise it to between 4.75% and 5%.
From a purely economic point of view, it almost doesn’t matter. In purely political terms, it could hardly be more important.
© 2022 The Economist Newspaper Limited. All rights reserved. From The Economist published under license. The original article can be found at www.economist.com.