– Once Predisposed Toward More Aggressive Moves, Fed Must Now Weigh Financial Risks
By Steven K. Beckner
(MaceNews) – The Federal Reserve finds itself in an awkward situation as it approaches its mid-March monetary policy meeting.
Less than a week ago, it seemed, the Federal Reserve’s policy making Federal Open Market Committee was on the verge of returning to a more aggressive pace of short-term interest rate hikes at its March 21-22 meeting. Now, an unexpected outburst of bank failures and related financial turmoil has made that outcome unlikely.
Faced with the dilemma of how to continue the fight against elevated inflation while not aggravating financial instability, the FOMC is almost sure to stay on the more incremental path of rate hikes it had moved to in recent months.
It’s an uncomfortable, if not embarrassing situation for the central bank, which aside from making monetary policy is the nation’s leading bank supervisor and guarantor of the financial system, not just domestically but internationally.
What a turn of events! After confidently slowing the pace of interest rate hikes at its last two meetings, the FOMC faced a difficult choice at its upcoming meeting – whether to admit it was wrong about inflation (again) and re-accelerate its monetary tightening.
There seemed to be ample economic justification for Chair Jerome Powell and his FOMC colleagues to revert to raising the federal funds rate by 50 basis points on March 22. Indeed, that became the widespread market expectation.
But now things look very different in the wake of the sudden collapse of Silicon Valley Bank and Signature Bank, which in turn has created waves of unease, most notably affecting Credit Suisse. The Fed has been forced into the breach, along with the U.S. Treasury and the Federal Deposit Insurance Corporation.
The FDIC made whole all depositors, above and beyond the $250,000 per account limit, and the Fed rushed in to provide liquidity through a new facility. The so-called Bank Term Funding Program that will lend as long as a year to banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral at par.
Rightly or wrongly, the Fed is being accused of helping to bring on the banking problems with its 450 basis points of rate hikes over the past year.
Prior to this explosion of financial distress, a series of discouraging reports showing elevated inflation, strong consumer demand and tight labor market tightness, coupled with hawkish Fed pronouncements, had fueled speculation that the FOMC would ratchet up rates more rapidly at the upcoming meeting.
However, in just the past few days, high profile bank failures and consternation about potential contagion to other parts of the financial services industry have provoked doubts as to whether the FOMC will raise rates at all.
As it has so many times before, the Fed faces a predicament. Fighting inflation or fighting financial vulnerabilities. Pick your poison.
Before all the banking consternation unfolded, Powell had put the option of a larger rate hike firmly on the table during two days of testimony on the Fed’s semi-annual Monetary Policy Report to Congress, March 7-8, and since then the data have moved in that direction.
“Although inflation has been moderating in recent months, the process of getting inflation back down to 2% has a long way to go and is likely to be bumpy…,” he told the Senate Banking Committees. “(T)he latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”
And he added, “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
What’s more, Powell intoned, “Restoring price stability will likely require that we maintain a restrictive stance of monetary policy for some time.”
Reprising his testimony before the House Financial Services Committee the following day, Powell repeated the threat of faster rate hikes, although he stressed that no decision had been made and that the size of the March 22 rate hike would depend on the data.
Monetary policy has undergone quite a swing over the past year. After holding the funds rate near zero for two years and maintaining the pretense that worsening inflation was merely “transitory” far beyond the point of prudence, the FOMC belatedly started raising it a year ago, but only slightly at first – by 25 basis points on March 16, 2022, then by 50 basis points on May 4.
The Fed also started shrinking its balance sheet by $95 billion per month.
Finally, with inflation hitting the highest level in 40 years and approaching double digits in June of last year, the FOMC became more aggressive and reeled off four straight 75 basis point rate hikes.
But then, as hopes grew that cumulative rate hikes were slowing demand and curbing wage-price pressures, the FOMC began to back off. At their Dec. 13-14 meeting, Powell and his colleagues raised the funds rate just 50 basis points. But FOMC participants revised their funds rate projections higher in the Summary of Economic Projections published at that meeting, lifting the median funds rate projecton for the end of 2023 from 4.6% to 5.1% (a target range of 5% to 5.25%)
Then came a 25 basis point increase on Feb. 1, the eighth since leaving the zero lower bound, which took the funds rate to a target range of 4.5% to 4.75%. The thought was that “shifting to a slower pace will better allow the Committee to assess the economy’s progress toward our goals, as we determine the extent of future increases that we require to obtain a sufficiently restrictive stance,” as Powell told reporters on Feb. 1. Most other officials dutifully echoed that strategy.
In its Feb. 1 policy statement, the FOMC said it “anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.”
In a further hint that the FOMC would proceed cautiously in raising rates further, it added, “In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
The Feb. 1 rate hike, which was accompanied by mounting speculation that the FOMC might soon “pause,” left the funds rate within 50 basis points of the target range which FOMC participants projected it would reach by the end of 2023 in their December 14 SEP – a median of 5.1%.
But not long after the last meeting, there was a considerable changing of hearts at the Fed and on Wall Street – and for good reason.
Powell’s notion that a slower pace of rate hikes would give the FOMC latitude to patiently feel its way along toward an appropriate policy stance was a nice thought, but it wasn’t long before officials were having second thoughts, as worse than expected inflation data came in, accompanied by surprisingly strong consumer spending and job numbers.
First came the January employment report, which was widely described as “a blowout.” Not only did the unemployment rate drop to its lowest level since 1969, non-farm payrolls surged by a surprisingly large 517,000. Average hourly earnings grew a more rapid 4.4% from a year earlier.
Then, underscoring the economy’s resilience to Fed credit tightening, January retail sales
leaped by 3% — biggest one-month increase since March 2021.
Most alarming of all was the disappointing news on inflation. Slower rates of increase in various price indices had encouraged Powell and other officials to boast that “disinflation” had arrived and green lighted the deceleration of rate hikes.
Then came news that the Labor Department had revised up the December consumer price index to show a 0.1% increase, instead of the initially reported 0.1% decline. What’s more, the February CPI jumped a much greater than expected 0.5%, leaving it up 6.4% from a year earlier – down from last June’s 9.1% peak, but far above the Fed’s 2% target.
Excluding volatile food and energy, the core CPI increased 0.4% monthly and 5.6% from a year ago – also more than expected.
On top of the already ugly CPI and PPI, the price index for personal consumption expenditures (PCE) — the Fed’s preferred inflation gauge – rose 0.6% in January (headline and core), leaving the overall price index up 5.4% from a year ago and the core index up 4.7% from a year ago – both a tenth more than in December.
Suddenly, Powell and his colleagues were putting less emphasis on disinflation in goods and housing prices and putting more emphasis on persistent pressures on core services prices excluding housing. And there was a rhetorical shift toward admitting that getting inflation down to 2% was going to take longer than they had hoped.
Even ordinarily “dovish” officials sounded ferocious.
“(W)e must defeat inflation now,” Minneapolis Federal Reserve Bank President Neel Kashkari asserted. “Doing so without inflicting severe economic pain is a delicate balance. But striking that balance is our job…(N),ow we must determine when inflation is irrevocably moving lower.”
“We’re not there yet, and that is why I think we will need to raise the federal funds rate to between 5 and 5.25 percent and leave it there until well into 2024,” the FOMC voter continued. “This will allow tighter policy to filter through the economy and ultimately bring aggregate supply and aggregate demand into better balance and thus lower inflation…..”
Boston Fed President Susan Collins said, “inflation remains too high, and recent data – including several strong labor market indicators, as well as faster than expected retail sales and producer price inflation – all reinforce my view that we have more work to do, to bring inflation down to the 2% target.”
Fed Governor Michelle Bowman renewed her hawkish comments, saying, “I don’t think we’re seeing what we need to be seeing, especially with inflation. I think we’ll have to continue to raise the federal funds rate until we start to see a lot more progress on that.”
FOMC participants did not revise their funds rate projections at the last meeting, but if their temperature had been taken in ensuing weeks, their rhetoric suggested they might well have pushed the median up toward 5 ½ %, if not higher.
In hist post-FOMC press conference on Feb. 1, Powell had triumphantly pointed to spreading evidence of “disinflation.” But by the time he delivered the Monetary Policy Report March 7-8, he was singing a different tune. He was still chipper about disinflation in some areas (goods, housing), but was forced to put a lot more emphasis on persisting inflation.
“(I)nflationary pressures are running higher than expected at the time of our previous FOMC meeting,” the Fed chief conceded in his March 7-8 Congressional testimony. “From a broader perspective, inflation has moderated somewhat since the middle of last year but remains well above the FOMC’s longer-run objective of 2 percent….”
“(T)here is little sign of disinflation thus far in the category of core services excluding housing, which accounts for more than half of core consumer expenditures,” Powell said. “To restore price stability, we will need to see lower inflation in this sector, and there will very likely be some softening in labor market conditions. Although nominal wage gains have slowed somewhat in recent months, they remain above what is consistent with 2 percent inflation and current trends in productivity.”
He went on to say the FOMC was prepared to raise rates faster.
Since Powell issued his data-dependent warning of a potential return to 50 basis point rate hikes, the data have not been particularly friendly to staying on a more incremental course.
The February employment report, while not as overawing as the January report, still showed a seemingly quite robust labor market. True, the unemployment rate popped back up to 3.6%, as the labor force participation rate picked up a tenth to 62.5%. But non-farm payrolls rose a greater than expected 311,000. Average hourly earnings rose a tenth less than in January, but the year-over-year rate went up from 4.4% to 4.6%.
More recently, the February consumer price index suggested a return to inflation moderation. The headline CPI rose 0.4% over January and 6% from a year earlier – down from 0.5% and 6.4% respectively. It was the best inflation reading since September 2021.
Core CPI rose 5.5% year-over-year – slowest since December 2021. Needless to say, some prices were up much more.
But while these most recent inflation readings provide a small sense of relief, they were pretty much in line with expectations, and they left inflation far above the Fed’s 2% target, to which Powell and his colleagues have repeatedly committed themselves.
Powell and others have comforted themselves with the strength of the labor market, believing that gives them considerable leeway to tighten policy without causing undue pain. They have dared to continue hoping for a “soft landing,” even as recession warnings have mounted and the yield curve has become increasingly inverted.
Fed officials have felt free in recent months to deemphasize downside risks and focus on the upside, thanks to hefty job gains and ample job openings. In his Congressional testimony,
Powell avoided talking about downside risks to the economy or about over tightening, in contrast to the kind of comments which Fed officials were regularly making as the FOMC was slowing the pace of rate hikes.
In the same vein, Atlanta Fed President Raphael Bostic said, “I continue to believe that the economy packs sufficient momentum to weather higher interest rates, which will ultimately bring inflation down to our objective, without a major downturn. There may be some job losses, but my baseline forecast is for these to be mild relative to what was experienced during previous economic slowdowns.”
But there was always an element of whistling past the graveyard, as we’re now seeing. The truth is that the Fed’s job is not getting any easier the higher it takes rates. The housing industry and the manufacturing sector are feeling the pain. Layoff notices have proliferated.
And now, of course, there are other worrisome straws in the wind. Notably, two large regional banks went under, triggering a federal bailout of depositors.
Closely on the heels of the revelation that Silvergate Capital (SI), one of the crypto industry’s biggest banking partners, would shut down after suffering massive outflows from its digital asset clients, Silicon Valley Bank went under. The nation’s 18th largest bank, a big player in financing venture capital and startups, SIVB announced it would take a $1.8 billion loss while liquidating its entire short-term securities book and raising $2.25 billion fresh capital.
The next domino to fall was New York-based Signature Bank (SBNY), a big cryptocurrency player – the third largest bank failure in U.S. history.
These debacles triggered selling of bank stocks and deposit withdrawals when markets opened Monday, March 13.
The previous evening, the Fed, the Federal Deposit and Insurance Corporation joined with the U.S. Treasury in announcing “decisive actions to protect the U.S. economy by strengthening public confidence in our banking system.”
Treasury Secretary (and former Fed Chairman) Janet Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank “in a manner that fully protects all depositors,” i.e. above the statutory $200,000 deposit ceiling, and giving them access to their money starting Monday, March 13.
Yellen announced “a similar systemic risk exception” for Signature Bank and said “all depositors of this institution will be made whole. As with the resolution of Silicon Valley Bank, no losses will be borne by the taxpayer.” Shareholders and certain unsecured debtholders, on the other hand, were not protected, and senior management was removed.
Simultaneously, the Fed pledged to “make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.”
As usual, when these kinds of situations develop, Yellen declared “the U.S. banking system remains resilient and on a solid foundation.” Not everyone was reassured, to put it mildly.
Before the burst of bank failures hit, new Chicago Federal Reserve Bank President Austan Goolsbee advised against paying too much to financial risks in setting monetary policy: “The temptation can be to look at what’s easy to find and lean more on that—stock market, bond market, and other financial data that give instant reactions to news aboutthe economy and our policy announcements and tell us which way the markets want the Fed to move. But it is a danger and a mistake for policymakers to rely too heavily on market reactions. The thing is, our job is ultimately judged by what happens in the real economy.”
One wonders what Goolsbee thinks now.
Whatever Goolsbee and others may say, history teaches that the specter of financial instability inevitably raises doubts among investors and average Americans and casts a pall over financial markets. It also can’t help but color the FOMC’s deliberations. In the past the Fed was known to halt or even reverse Fed tightening when confronted with financial perturbations.
The saving grace, thus far, is that banks are better capitalized than they were before the 2008 financial crisis. This was largely a liquidity – and risk management – problem.
But one has to wonder if there are other shoes to drop. These recent problems in the crypto and banking sectors have unquestionably heightened financial instability risks, which in the past have tended to temper the Fed’s willingness to tighten credit.
At the very least, financial stability concerns increase uncertainty about the economic and financial outlook, which could make the Fed a bit more cautious about raising rates and at times have induced rate cuts.
So, at the current juncture, the Fed finds itself in a dilemma. While it seeks financial stability, its primary mandate is to preserve “price stability.” Its credibility as protector of the dollar’s purchasing power is at stake, particularly in wake of Powell and the FOMC’s loud declarations of war against inflation.
Powell, who has often called financial risks “manageable” and the banking system “sound” in recent years, and his colleagues have fervently sworn a commitment to reducing inflation to 2% at a time when inflation remains elevated far above that target.
Since the SVB eruption, the FOMC’s rate decision has become even more complicated than it already was.
Although the February CPI reading looked a tad better, it was in line with expectations and still showed inflation running three times target against a backdrop of strong demand, labor market tightness and wage-price pressures in the service sector. Other things equal, the inflation data would keep pressure on the Fed to tighten credit.
Now, having opened the door to a faster pace of rate hikes, Powell must find a way to justify staying with the slower pace if he is to guard the Fed’s anti-inflation credibility. The SVB eruption gives him at least a temporary pass – a rationale for shifting the focus away from inflation for the time being.
Greater financial risks and uncertainties, not to mention the yield curve inversion, together with the more moderate CPI report, gives the FOMC an excuse to raise the funds rate just 25 basis points. The voices advocating a 50 basis point rate hike will recede. Some will probably argue for holding rates steady.
Regardless of the size of the March 22 move, it still seems likely FOMC participants will make an upward revision to funds rate projections in the new SEP, although perhaps not as much as before the SIVB.