Financial tremors now muddying Fed inflation debate

US FEDERAL Reserve officials will meet next week again as they chase persistent inflation, but now they have to balance that against the first acute tremors from the aggressive interest-rate hikes that the central bank approved over the past year.

The sudden failure of Silicon Valley Bank (SVB) last week is not expected to prevent the Fed from continuing to raise interest rates at its Mar 21 to 22 meeting, with inflation still running far above the Fed’s 2 per cent target, and Fed chair Jerome Powell indicating that monetary policy might need to become even more aggressive.

But it could add a dose of caution to the policy debate and undermine the sense, common among officials so far, that Fed policy had not caused anything to “break” in an economy where spending and job growth have seemed immune to the impact of higher interest rates.

SVB’s failure, which the Fed views as a potentially systemic shock if bank depositors faced losses, prompted the Fed to announce on Sunday (Mar 12) a new bank lending facility, in an effort to maintain confidence in the system. This effectively put the Fed back in the business of emergency lending, even as it tries to tighten credit overall with higher interest rates.

Given the stakes, that bit of dissonance seemed unavoidable, and may be accompanied by a slightly softer approach to monetary policy, if risks intensify.

“The threat of a systemic disruption in the banking system is small, but the risk of stoking financial instability may well encourage the Fed to opt for a smaller rate increase at the upcoming meeting,” Oxford Economics economist Bob Schwartz wrote on Friday, after SVB was closed by regulators, and as officials began to examine how to respond to the largest bank failure since the financial crisis from 2007 to 2009.

The upcoming Fed session was already providing a reality check of sorts, as policymakers tried to understand why the rapid rate hikes of last year have not had more of an impact on the pace of price increases.

The inflation rate in January actually rose, while an Atlanta Fed real-time projection as at Mar 8 showed gross domestic product expanding at a 2.6 per cent annual rate, well above the economy’s roughly 2 per cent underlying potential.

Officials were poised to push the expected path of interest rates higher yet again as a result, the third time in their two-year battle against inflation that US policymakers will have shifted on the fly after price increases proved to be faster, broader and more persistent than expected in their forecasts.

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A February jobs report released on Friday showed the unemployment rate rising to 3.6 per cent. More importantly for the Fed, monthly wage growth slowed even as the economy continued to add jobs, an outcome that leaves open whether the Fed will approve a quarter- or a half-point rate increase at its next meeting. By late Sunday, after the day’s emergency actions, the probability of a half-point hike had diminished to below one in five.

New inflation data to be released on Tuesday and retail sales data on Wednesday both have the potential to push policymakers in either direction at the two-day meeting, which concludes Mar 22 with a new Federal Open Market Committee statement, projections issued at 1800 GMT, and a press conference by Powell.

While investors at this point expect lower odds of a return to larger rate hikes, there is still the question of just how much higher the Fed will go overall. Powell, in his remarks to Congress last week, signalled that the new “dot plot” of projections for the rate path beyond March would likely be higher than previously expected, in order to slow inflation to the central bank’s 2 per cent target from levels more than double that.

As at December, the high point for the target federal funds rate was expected by most officials to be 5.1 per cent. In their final public comments before the beginning of a pre-meeting blackout period, Fed officials other than Powell also said that they were primed for a more aggressive response, if upcoming data show them losing more ground to inflation.

“The ultimate level of interest rates is likely to be higher than previously anticipated,” Powell said in congressional testimony that reset expectations for where the Fed was heading, pushing yields on US Treasury bonds higher, and prompting a sell-off in equity markets.

At a Feb 1 press conference, in contrast, his focus was on a “disinflationary process” that he said was taking root.

However, developments since then have raised some doubt in investors’ minds whether Fed officials would follow through with that. Much of the immediate heat on bond yields and rate expectations eased after Friday’s employment data, with the weekend’s developments in the banking sector to address the SVB collapse also factoring into the reversal.

Government reports released after Powell’s last press conference showed that the central bank’s preferred measure of inflation had risen slightly to a 5.4 per cent annual rate.

Revisions to prior months also erased some of the progress that policymakers had relied on when they decided to step down to quarter-point rate hikes at their last session. A New York Fed study last week suggested moreover that current inflation was being driven more by persistent factors, and less by cyclical or sectoral influences that might be quicker to dissipate.

It is not the first time that the Fed has been caught out by after-the-fact data updates. In the fall of 2021, the first release of monthly jobs reports seemed to show the job market weakening, taking some of the urgency out of discussions about when to start tightening monetary policy. By the end of the year, revisions showed that hundreds of thousands more jobs had been added than originally estimated.

“If you are trying to be nimble, this is the risk. And Powell is trying to be nimble,” said former Fed economist John Roberts. REUTERS