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

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

The challenge for the Fed is to figure out how to support banks and cool inflation at the same time without triggering a recession. While the Fed can theoretically pursue a dual-track approach, the risk is that a continued increase in interest rates will further strain an already weakened financial sector.

“Their job just got significantly more complicated,” said Mark Zandi, chief economist at Moody’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 pullback in consumer and business spending, at least marginally, and that the Fed should wait to see whether its emergency lending actions have successfully eradicated 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 due to 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. It’s taking place as inflation remains well above the Fed’s 2% target and is even accelerating by some measures. While financial volatility is cause for caution, the economic data released since it began continues to point to the need for further rate hikes.

February consumer price index data released on Tuesday showed core consumer prices rose 0.5% over the month. Retail sales data released on Wednesday showed underlying strength in core control sales, which rose 0.5%. And on Thursday, new applications to the social security fund fell, while housing starts rose. Both exceeded expectations and confirmed that economic resilience continues.

The European Central Bank also went ahead on Thursday with plans it had laid out before the banking chaos began, raising interest rates by half a point. Its action 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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Everything 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 point at its next meeting, despite last week’s chaos.

“What’s still true here, even though we have a lot of news coming out, is that inflation is still very much entrenched in these sticky service sector categories that are just hard to root out,” said Thomas Simons, an economist at Jefferies. “If the Fed were to pause here, I’m very concerned about inflation expectations again.”

For the Fed, a pause in its monetary tightening campaign now would run counter to Chairman Jerome Powell’s pledge that the central bank will not give up its fight for price stability until inflation is well back to its 2% target, economists say. Forgoing a hike could send a message that the central bank is not yet convinced it has done enough to restore financial stability.

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What’s more, if a pause is interpreted as a sign that the Fed is done raising interest rates, it could contribute to a perception that violent price growth is here to stay. That, in turn, could cause a shift in consumer behavior that ultimately makes it harder to curb inflation back to 2%.

“The strongest argument for continuing to hike at the meeting a week from now is that if they don’t, the markets will be asking, ‘Is this the end of Fed rate hikes?’ ” says Andrew Hollenhorst, chief US economist at Citi. “If this is 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 fall to 2%?”

What the Fed will do is still unclear, not least because the decision is still almost a week away. But investors are starting 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 recovering most of their losses. But economists say the collapse of Silicon Valley Bank hasn’t greatly changed their view of the economy. While some economists who spoke to Barron’s said risks are now more heavily weighted on the downside, and that a recession could potentially come a little sooner than previously expected, no one had made major changes to their growth outlook or predicted an imminent collapse.

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

“While highly uncertain, given the speed with which events are unfolding, the impact of the bank crashes 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 past few days, but this banking crisis is not likely to push the economy into recession.”

Write to Megan Cassella at

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