U.S. central bankers face uphill task in tackling inflation and financial instability after bank collapse

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19th March 2023 – (Washington) U.S. central bankers face a daunting challenge as they convene in Washington next week: how to combat persistent inflation without exacerbating financial sector instability in the wake of Silicon Valley Bank’s sudden collapse.

In response to historically high inflation rates, the Federal Reserve has raised interest rates eight times since last year, hoping to stabilize the economy without triggering a recession. While Fed Chair Jerome Powell previously indicated a willingness to accelerate interest rate hikes if necessary, most analysts and traders anticipate a modest increase of 25 basis points as the most probable outcome at the conclusion of the Fed’s two-day meeting on Wednesday, March 22nd.

Such a quarter-percentage-point hike would match the magnitude of the Fed’s last increase in February. However, some market observers, alarmed by the rapid failures of three mid-sized lenders earlier this month, believe that the Fed may halt its rate increases altogether.

The sudden collapse of Silicon Valley Bank (SVB) was catalyzed by the Fed’s quick shift from near-zero interest rates to steep hikes, which promptly reduced the value of SVB’s holdings linked to long-term US Treasury bonds. In light of the market turbulence, Citigroup global chief economist Nathan Sheets opined that a more substantial 50 basis-point hike is “off the table.” He did, however, caution that “it’s going to be a debate, and where markets are next Tuesday and Wednesday is going to be critical.”

SVB’s collapse on 10th March was the largest banking failure since the 2008 financial crisis. This, combined with the collapse of New York’s Signature Bank a few days later, triggered a sell-off in regional banking stocks and led many analysts to believe that the Fed would abandon an anticipated increase in the pace of hikes.

Powell informed senators earlier this month that it may be necessary to raise the benchmark lending rate to curb the “widespread” inflationary pressures that are keeping price increases elevated above the bank’s long-term target of 2 percent. In response, futures traders priced in a 50-basis point increase, according to CME Group.

However, the financial turmoil generated by SVB’s failure caused a significant shift in expectations. The stresses in the financial sector are likely to have weakened the Fed’s determination to move more aggressively on 21st and 22nd March, according to Bank of America U.S. economist Michael Gapen. “We believe the debate is now between a 25 (basis points) rate hike in March or none at all,” he stated in a note to clients.

Data from February shows that some segments of the American economy are starting to contract, providing the Fed with some relief as it contemplates another interest-rate hike. U.S. retail sales and wholesale prices fell slightly last month, although the consumer price index measure of inflation remained elevated at an annual rate of 6 percent.

However, the Fed’s preferred measure of inflation showed an annual increase in January, indicating that there is still a long way to go before price rises are brought back under control. Turmoil in the banking sector is also ongoing, with many regional banks experiencing significant stock losses despite intervention by U.S. regulators and some of Wall Street’s biggest banks.

“At a minimum, stress in financial markets suggests the Fed should proceed with caution,” warned Bank of America’s Gapen.