Fed raises rate .25 against a backdrop of bank solvency fears

Squeezed between unrelenting inflation on one side and a sudden wobbly banking sector on the other, the Federal Reserve on Wednesday split the difference and raised interest rates just a quarter point to continue battling inflation while calming jittery banks.

In what one columnist called a classic Scylla and Charybdis situation (Google it), the Fed was really in a hard place with no way to balance both raging inflation and the banking turmoil. Fed chairman Jerome Powell said the central bank had considered “a pivot” and pausing interest rate hikes in light of the banking turbulence but that the economic data still called for trying to rein in escalating prices by again tweaking interest rates.

SVB collapse an 'outlier'

He said it was too early to know how much the bank situation – notably the sudden failures Silicon Valley Bank and Signature Bank – is going to slow the economy. He said, however, he believed the SVB collapse is an “outlier” with huge uninsured deposits and that “deposit flows in the banking system have stabilized.”

The Fed’s move Wednesday put its benchmark interest rate target between 4.75 percent and 5 percent. In updated economic projections also released Wednesday, Fed officials indicated they would hike the rate one more time in 2023, putting it at just above 5 percent.

In a written statement, the Fed’s monetary policymaking committee said “the U.S. banking system is sound and resilient,” and that recent developments “are likely to result in tighter credit conditions for households and businesses” and would impact economic activity, hiring, and inflation.

“I think the Fed is trying to convey a cautious approach, but also not to set off any alarms that they're so worried about the banking crisis that they're going to stop raising rates and potentially lower them,” said David Sacco, finance professor at the University of New Haven. “Ultimately a bank run is a crisis of confidence, not even necessarily the stability of the bank or liquidity of the bank. It's really a crisis of confidence and I don't think they want to exacerbate that.”

Fed's rate hike largely predicted

The quarter point rise in rates was largely predicted after the recent jolts to the banking sector and the market took the news mostly in stride with the Dow Jones Industrial Average dropping just slightly in mid-day trading.

Still, other analysts believed that the banking crisis itself would lead to tightening credit so there was no need for the Fed to exacerbate the situation with a rate hike of its own.

“Teetering confidence in the banking sector, even if currently contained to a small number of banks, offered the Federal Reserve a perfect opportunity to pause without signaling that it was throwing in the towel on inflation,” said Marty Green, principal of Polunsky Beitel Green, a law firm for residential mortgage lenders. “Instead, the Federal Reserve appears to be continuing to dance to last month’s music, not fully aware that the tune is vastly different today.”

Others believe it would have been wise for the Fed to stand down on rate hikes.

“Banks are under pressure due to the current market environment, which will make them much more conservative in their broad strategy toward providing credit,” said Santiago Guzman, CEO of Cap8, in Boston. “Additionally, there is a high correlation between the financial sector and the real economy, and the relationship between economic activity and inflation is evident. If one of the three is unclear, which is the case today, the Fed needed to take a step back and not add fuel to uncertainty."

Guzman’s colleague, Cap8 CTO Joseph Péteul, said the Fed was caught off guard by the sudden banking crisis and the ancillary cracks in the tech sector.

“This sector was bloated with cash in 2021 and has been bleeding since the beginning of this rate cycle,” he said. “It is unclear if the Fed has developed the proper tools to monitor this sector specifically and to model the impact on the rest of the economy."

Despite the uncertainty Chairman Powell said he still believes that reducing inflation to around 2 percent is a viable goal this year.

“There is a pathway,” he said. “And we’re trying to find it.”

Doug Bailey is a journalist and freelance writer who lives outside of Boston. He can be reached at [email protected].