The Fed’s New Bonds: Taming Inflation While Preventing Financial Chaos

The chaos in the banking sector has led to calls for the Federal Reserve to halt or even reverse the pace of monetary policy. February’s economic data, meanwhile, show that the labor market remains strong and that inflation remains pervasive, underscoring how much work the central bank still has to do to curb inflation.

The challenge for the Fed is to figure out how to strengthen banks and cool inflation at the same time, without triggering a recession. Although the Fed could theoretically pursue a two-track approach, the risk is that continuing to raise interest rates will further strain an already weakened financial sector.

“Their job became significantly more complicated,” says Mark Zandi, chief economist at Moody̵[ads1]7;s Analytics.

Arguments for a pause in monetary policy tightening center on fears that recent bank failures and heightened recessionary expectations will lead to a decline in consumer and business spending, at least marginally, and that the Fed should wait to see if the emergency loans their actions have succeeded in stop the banking crisis before it raises interest rates further.

Some economists also warn that the collapse of two regional banks is likely to make banks less eager to lend, thereby tightening credit conditions and doing some of the Fed’s job of slowing the economy. Goldman Sachs economists estimated on Wednesday that the “incremental tightening of lending standards” they expect as a result of ongoing stress on small banks would have the same effect as about 25 to 50 basis points, or 0.25 to 0.50 percentage point, of interest rates. increases.

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But the banking crisis does not happen in a vacuum. That’s taking place as inflation remains well above the Fed’s 2% target and is even accelerating by some measures. Although financial volatility is cause for caution, the economic data released since it began continues to suggest that further rate hikes are needed.

February’s consumer price index data, released on Tuesday, showed that core consumer prices rose 0.5% over the month. Retail trade data released on Wednesday showed underlying strength in core sales, which rose 0.5%. And on Thursday, new applications for unemployment benefits fell while housing starts rose. Both exceeded expectations and confirmed that economic resilience persists.

The European Central Bank also went ahead on Thursday with plans it had made before the banking chaos began, raising interest rates by half a point. The move suggests that at least some central bankers feel they can continue to tighten monetary policy and tackle inflation while still navigating new uncertainties and working to stabilize the financial sector.

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Like everyone means the Fed cannot abandon its inflation battle even as it addresses the issue of financial stability among regional banks, economists say. And that means the Fed will have to raise interest rates by a quarter of a point at its next meeting, despite the chaos of the past week.

“What remains true here, even though we have a lot of news coming in, is that inflation is still very much anchored in these sticky service sector categories that are very difficult to eliminate,” said Thomas Simons, an economist at Jefferies. “If the Fed were to pause here, I’m very concerned that inflation expectations will take off higher again.”

For the Fed, a pause in the monetary policy tightening campaign would now run counter to Chairman Jerome Powell’s promise that the central bank will not abandon its fight for price stability until inflation is well on its way back to the 2% target, economists say. Refraining from an increase could send a message that the central bank is not yet convinced that it has done enough to restore financial stability.

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Also, if a pause is interpreted as a sign that the Fed is done raising interest rates, it could contribute to a view that a surge in prices is here to stay. That, in turn, could lead to a change in consumer behavior that ultimately makes it harder to slow inflation back down to 2%.

“The strongest argument for continuing to hike at the meeting a week from now is, if they don’t, then the markets are going to ask, ‘Is this the end of Fed rate hikes?’ said Andrew Hollenhorst, chief U.S. economist at Citi. “If it’s the end of Fed rate hikes, then inflation is still too high and the economy still looks overheated. So why should there be confidence that inflation is going to come down to 2%?” »

What the Fed will do is still unclear, not least because the decision is still almost a week away. But investors have started to come around to the idea of ​​a quarter-point rate hike, with data from the CME FedWatch tool showing a more than 80% chance Thursday afternoon of a hike of that size.

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Traders have been spooked by the latest turmoil, and stock markets plunged on Wednesday before paring most of the losses. But economists say the collapse of Silicon Valley Bank has not greatly changed their view of the economy. While some economists who spoke to Barron’s said risks are now more heavily weighted to the downside, and that a recession could potentially come a little earlier than previously expected, no one had made major changes to the growth outlook or predicted an imminent collapse.

Instead, they mostly saw disruptions in the banking sector – at least for now – as more isolated weakness than a symbol of broad economic disaster.

“Although highly uncertain, given the speed with which events are unfolding, the impact of the bank failures on the economic outlook should be marginal,” Zandi wrote this week. “The economy will struggle this year and next, and will remain vulnerable to events like the last few days, but this banking crisis is not likely to push the economy into recession.”

Write to Megan Cassella at

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