The Federal Reserve kicked off its policy-setting meeting this week confronting one of the toughest decisions in years: continue its war against stubborn inflation and raise interest rates again or put that fight on hold amid a global banking crisis.
Hiking interest rates could exacerbate instability within the financial system, but pausing risks allowing inflation to become entrenched in the economy or to roar back with a vengeance.
"Recent banking sector volatility, coupled with a February CPI report that shows inflation is still running hot, means the Federal Reserve now has a stability dilemma: Cut rates to alleviate market angst and risk spurring inflation higher or, alternatively, persist with aggressive rate hikes to avoid reinvigorating inflation, but risk accelerating contagion to the broader financial system," said Seema Shah, chief global strategist at Principal Asset Management.
"Their decision to favor either price stability or financial stability will be instructive for the crisis outlook moving forward."
Most economists expect the central bank to forge ahead with its rate-hike campaign and approve a quarter percentage point increase at the conclusion of its meeting Wednesday afternoon. The probability that the Fed delivers another rate hike this month rose to more than 83% Tuesday, according to the CME Group's FedWatch tool, which tracks trading. That compares to about 16% of traders who expect the Fed to pause its rate-hike campaign.
The move would set the federal funds rate between 4.75% to 5%, further restricting economic activity as the borrowing costs for homes, cars and other items march higher. It would mark the highest rate level since 2007.
"February’s CPI report confirms that the inflation problem is still very present, and, on its own, would likely have cemented a 50 basis point hike," Shah said. "However, with the recent bank failures sending the financial sector into disarray, the Fed will likely need to put extra focus on the financial stability side of its mandate. As a result, a 25 basis point hike is the most likely outcome from the FOMC meeting."
Over the past year, the U.S. central bank has raised the federal funds rate eight times, underscoring just how serious policymakers are about tackling the inflation crisis. The ninth increase was just around the corner, with Chairman Jerome Powell even suggesting earlier in March that the Fed may need to pick up the pace of increases amid signs of broadening inflationary pressures within the economy.
The hawkish commentary prompted investors to reevaluate their expectations for the meeting, with many ramping up the odds that the Fed approves a half percentage point hike during its March 21-22 meeting.
But Wall Street no longer sees that as a possibility after the stunning implosion of on Silicon Valley Bank March 10 roiled global markets and triggered fears of a broader financial meltdown.
Silicon Valley Bank collapsed after a liquidity crunch, forcing a government takeover and raising questions over the fate of nearly $175 billion in customer deposits. It marked the largest U.S. bank failure since the global financial crisis in 2008, and rising interest rates played a pivotal role in SVB's collapse.
That's because SVB, which largely catered to tech companies, venture capital firms and high net worth individuals, saw a huge boom in deposits during the pandemic, with its assets surging from $56 billion in June 2018 to $212 billion in March 2023. The bank responded by investing a large chunk of that cash into long-term U.S. Treasury bonds and other mortgage-backed securities. But when the Fed started rapidly raising interest rates, the value of those securities tumbled.
That coincided with a decline in available funding for startups, which started drawing down more of their money to cover their expenses, forcing the lender to sell part of its bond holds at a steep $1.8 billion loss. When depositors realized that SVB was in a precarious financial situation, a bank run ensued.
The bank's collapse, coupled with another failure at Signature Bank and turmoil at Swiss lender Credit Suisse, drastically altered rate hike bets on Wall Street. Former Boston Fed President Eric Rosengren indicated on Wednesday that he believes the central bank should pause its rate-hike cycle in the wake of the two bank failures within the U.S. and the uncertainty over Credit Suisse.
"Financial crises create demand destruction. Banks reduce credit availability, consumers hold off large purchases, businesses defer spending. Interest rates should pause until the degree of demand destruction can be evaluated," Rosengren said in a tweet.
At the same time, recent data still points to inflation that is running about three times higher than the pre-pandemic average.
"The Federal Reserve is going to have to pick its poison: tolerate some inflation for a bit to see if its current series of rate hikes takes hold and pause or keep hiking and deal with the financial instability caused by their own policy decisions," said Jamie Cox, a managing partner for Harris Financial Group.