SVB collapse shakes expectations for US Federal Reserve interest rate decision

The much-anticipated March 22 Federal Reserve interest rate decision is just a week and a half away, and the drama that gripped the banking and financial sectors over the weekend is drastically shaking expectations for central bank results.

The Fed had been quick to raise interest rates to stem the most painful surge in inflation since the 1980s, raising them to over 4.5 percent from almost zero a year earlier. Concerns about rapid inflation prompted the central bank to hike four consecutive 0.75 points last year before slowing to half a point in December and a quarter point in February.

Ahead of this weekend, investors believed there was a significant chance the Fed would make a half-point hike at next week’s meeting. That move to the upside was seen as an option as job growth and consumer spending have shown surprising resilience to higher interest rates – prompting Fed Chair Jerome H. Powell to signal just last week that the Fed was planning a bigger one step would consider.

But investors and economists no longer see that as likely.

In the past week alone, three big-name banks have failed as Fed rate hikes bounced back through the tech sector and cryptocurrency markets, even upending normally staid banking models.

Regulators announced sweeping intervention Sunday night to prevent panic from spreading across the broader financial system, with the Treasury Department, the Federal Deposit Insurance Corporation and the Fed saying depositors at the failed banks will be repaid in full. The Fed announced an emergency lending program to channel cash to banks suffering large losses on their holdings due to interest rate changes.

The Sinking of the Silicon Valley Bank

One of the most prominent lenders in the world of tech startups collapsed on March 10, forcing the US government to step in.

The turmoil — and the risks it entails — could make the central bank more cautious as it pushes forward.

Investors have abruptly downgraded the number of rate moves they expect this year. After Mr Powell’s speech last week opened the door to a big rate hike at the next meeting, investors had sharply upgraded their forecasts for 2023, even factoring in a tiny chance that rates would rise above 6 percent this year. But after the wild weekend in finance, they see little movement this month and expect the Fed to cut rates to just over 4.25 percent by the end of the year.

Economists at JP Morgan said the situation strengthened the case for a smaller quarter-point move this month.

“I don’t hold that view with much confidence,” said Michael Feroli, chief US economist at JP Morgan, explaining that a move this month would depend on the proper functioning of the banking system. “We will see if these backstops are enough to address concerns. If they succeed, I think the Fed will want to continue down the policy tightening path.”

The economists at Goldman Sachs no longer expect interest rates to move at all. While Goldman analysts still expect the Fed to hike rates above 5.25 percent this year, they wrote Sunday night that they see “significant uncertainty” about the path.

“I think the Fed is going to want to wait a while to see how that plays out,” said William English, a former director of monetary affairs at the Fed who is now at Yale. He explained that shocks in the banking system could spook lenders, consumers and businesses – which would slow the economy and mean the Fed would have to do less to cool the economy and bring down inflation.

“If it were me, I’d rather take a break,” said Mr. English.

Other economists went even further: Nomura, which said it was unclear whether the government’s stimulus program would be enough to halt problems in the banking sector, is now calling for a quarter-point rate cut at the upcoming meeting.

The Fed will have fresh information on inflation on Tuesday when the CPI is released. That metric is likely to have risen 6 percent over the year to February, economists expected in a Bloomberg forecast. That would be a slight drop from 6.4 percent at a previous reading.

However, economists expected prices to rise 0.4 percent from January after food and fuel prices, which have fluctuated wildly, are scrapped. That pace would be fast enough to suggest that inflationary pressures were still unusually persistent – which would typically argue for a strong Fed response.

The data could underscore why this moment is a major challenge for the Fed. The central bank is responsible for fostering stable inflation, which is why it has been raising interest rates to slow spending and business expansion, hoping to curb growth and moderate price increases.

But it’s also tasked with maintaining the stability of the financial system, and higher interest rates can reveal weaknesses in the financial system — as evidenced by Friday’s Silicon Valley bank explosion and the huge risks facing the rest of the banking sector. This means that these goals can conflict.

Subadra Rajappa, head of U.S. interest rate strategy at Société Générale, said Sunday afternoon that she thinks the evolving banking situation is a warning of rapid and drastic rate hikes – and said tackling banking instability is the Fed’s job would make it “more difficult” and force it to balance the two jobs.

“On the one hand, they have to raise interest rates: that’s the only tool they have” to control inflation, she said. On the other hand, “it will reveal the weakness of the system”.

Ms. Rajappa likened it to the old adage about the beach at low tide: “You’ll see who’s been swimming naked when the tide recedes.”

Some saw the Fed’s new lending program – which will allow banks suffering from the high-yield environment to temporarily transfer some of the risk they face from higher interest rates to the Fed – as a sort of insurance policy that could allow the central bank to do so to continue raising interest rates without causing further disruption.

“The Fed basically just bought interest rate risk insurance for the entire banking system,” said Steven Kelly, a senior research associate at Yale’s Financial Stability Program. “They’ve basically taken over the banking system and that gives them more leeway to tighten monetary policy.”

Joe Rennison contributed reporting.

Audio produced by Parin Behrooz.