How will the banking crisis impact the Fed? Higher rates and recession may be imminent

The meeting comes after weeks of economic turbulence, including high inflation, strong jobs growth and a banking crisis — and experts expect that it will result in another interest rate hike.

Here’s what you should know about the Fed’s upcoming meeting, and what to expect going forward.

What is the Fed?

The Federal Reserve is the United States’ central bank. It is responsible for setting monetary policy — the actions that aim to help the country achieve things like price stability, low unemployment and target economic growth.

The Fed also oversees individual financial institutions, like banks and insurers, and works to promote consumer protection.

Within the Fed, the Federal Open Market Committee (FOMC) is responsible for setting monetary policy. This influences how much it costs to borrow money and how much credit is available to be borrowed. It also determines the returns that savers earn.

The Fed is “independent within the government,” which means it operates as its own governmental agency but is accountable to Congress and the public.

Why has the Fed been raising interest rates?

Part of the FOMC’s job is to stabilize the economy in response to changes in employment, inflation and long-term interest rates.

The committee’s main method is changing the federal funds rate – which is “the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight,” according to the Federal Reserve Bank of St. Louis via the Fed’s Board of Governors.

Interest rates determine borrowing costs, which in turn influence the spending decisions that individual consumers and businesses make.

When interest rates are low, people are more likely to spend more because it is cheaper to borrow money and there is more credit available. This might mean more households are encouraged to get a mortgage on a new home or take out a loan for a new car. Businesses might be more inclined to borrow money to expand their operations or to hire more employees.

But when interest rates are high, people are less likely to spend money because it costs more to borrow.

The Fed wants to achieve an interest rate that promotes a stable economy – which is defined by “maximum sustainable employment, low and stable inflation and moderate long-term interest rates.”

While there is no set number for employment or interest rates, the Fed set its inflation target at 2%.

Since the start of the COVID-19 pandemic in March 2020, the economy has seen wild fluctuations in employment, inflation and interest rates.

In an attempt to soften the blow of the pandemic, the Fed cut its target for the federal funds rate by a total of 1.5 percentage points in March 2020. This decision sought to encourage continued spending by lowering how much it cost households and businesses to borrow money.

Low interest rates combined with looser monetary policy and more financial support for businesses and households gave people a lot of money to spend as daily life saw less disruption.

This consumer demand was met with a mismatched supply since production had slowed during the pandemic. In other words, goods and service suppliers could charge more for their products because there was low supply and high demand and many consumers were willing and able to pay more.

Ultimately, this drove inflation up, and created a big issue for the Fed as it tried to maintain stability throughout the economy.

To moderate rising prices, the Fed began raising interest rates in March 2022 after a 2-year hiatus. Between March 2022 and February 2023, the FOMC has raised its target from between 0.25-0.50% to 4.5-4.75%.

Have the Fed’s rate hikes been working?

Despite eight consecutive rate hikes in the past year, the economy remains stronger than what the Fed wants to see.

Inflation bottomed out at 0.23% in May 2020, and peaked at almost 9% in January 2023, according to data from the Fed. As of February 2023, inflation was still running hot at 6% – far above the Fed’s goal.

Unemployment has been unstable since the start of the pandemic. In April 2020, unemployment peaked at 14.7%, according to data from the Bureau of Labor Statistics. As of February 2023, unemployment is much lower at 3.6%, indicating that the labor market remains strong.

The number of jobs being added to the economy has also been higher than expected – and higher than what the Fed wants. In January, the U.S. saw a blow-out jobs report, indicating that 517,000 new jobs were added.

This growth slowed in February, and the U.S. only added 311,000 jobs, according to BLS data. Although lower than January’s gains, this was still higher than was experts expected, and provided further proof that the economy is remaining resilient despite the Fed’s attempts at a slowdown.

So have the Fed’s rate hikes been working? And if not, will they ever work?

Experts say it’s a bit complicated, but there’s hope.

Monetary policy typically takes time to have a direct impact, so there’s usually a lag between its implementation and when it takes effect. Since November, the Fed has noted that it is considering this delay when it’s making its decisions.

Data indicates that it typically takes between 18 months to two years for monetary policy to have a material impact on inflation, according to the president and CEO of the Atlanta Federal Reserve, Raphael Bostic.

“To be sure, there is considerable uncertainty about how these policy lags will play out. We are still learning about an economy that is rapidly changing after an unprecedented global pandemic and other surprising events, such as the war in Ukraine, that shocked important economic sectors,” Bostic said in a November news release.

Some parts of the economy are more sensitive to rate hikes while others take longer to feel the shock.

Residential real estate, for example, is quickly impacted by the FOMC’s interest rate decisions. GDP growth on the other hand takes a longer time to respond.

With this in mind, it appears the Fed’s rate hikes are working, albeit slowly, according to Ryan Sweet, Chief U.S. Economist at Oxford Economics.

“The Fed’s rate hikes are working. It’s just taking time in the long and variable lag between when the Fed raises interest rates and when it starts to affect GDP growth,” Sweet told McClatchy News.

Still, this progress might not be enough, according to Joseph Gagnon, senior fellow at the Peterson Institute for International Economics.

“There are isolated signs that it’s having an effect and there are lags in the process that takes time,” Gagnon told McClatchy News. “But I think they feel like they haven’t gone quite far enough yet. And they could go further.”

Will the Fed raise rates in March?

The FOMC will meet March 21-22 to determine its next move.

At their meeting in February, the Fed raised rates only a quarter of a point, the lowest increase since March 2022. Experts at the time expected the next rate hike to follow suit.

That is until inflation and jobs data from February came back strong. After these latest numbers, a half-point raise became more likely.

In a March 8 testimony to Congress, Fed Chair Jerome Powell suggested that due to rising prices and the robust labor market, a bigger increase might be in store, The Washington Post reported.

“Markets thought if anything a half a point raise was more likely because the news on inflation and jobs has been pretty strong. Inflation is slowing down but not as fast as the Fed would like and jobs are growing faster,” Gagnon said.

Outlooks were further complicated after the collapse of Silicon Valley Bank and the shutdown of Signature Bank.

Now, experts are torn on the Fed’s next move. Some are arguing that the Fed will pause its tightening, holding off on another rate hike until its next meeting to give banks time to recuperate.

Others suggest a quarter or even half point hike is still imminent, pointing to the Fed’s responsibility to manage inflation and employment.

The collapse of the banks could also have a cooling effect on the economy, making a higher rate hike less necessary, according to Sweet, who foresees a quarter point hike.

“The Fed’s got a dual mandate of full employment and stable prices and inflation is still well above their target. So they’re most likely going to keep hiking interest rates,” Sweet said. “They may not have to hike as much as previously thought because of the tightening of financial market conditions. And these bank failures are likely going to weigh heavily in overall sentiment in the banking system and will reduce loan growth, so banks are gonna make fewer loans on commercial industrial loans and consumer and that will, by extension, help cool the economy even further.”

Are we at risk of a recession?

As the Fed’s fight against inflation continues and rate hikes persist, the potential for a recession remains on the table — which is defined as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months,” by the The National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee.

Some experts think there is still a chance that the U.S. can stabilize its economy without slipping into recession while others argue a recession is inevitable if the Fed is to achieve its 2% goal.

“We have a recession starting in the third quarter of this year. And historically, recessions have been very disinflationary that helps take a lot of pressure off inflation,” Sweet said. “I don’t think the Fed would come out and publicly say that they’re rooting for a mild recession, but that would help them; that would be one way of getting inflation back down to their target more quickly.”

The banking crisis has only made things worse, Jay Bryson, chief economist at Wells Fargo, told the New York Times.

“There will be real and lasting economic repercussions from this, even if all the dust settles well,” Bryson said. “I would raise the probability of a recession given what’s happened in the last week.”

The Fed initially had hoped to reach their goal of 2% and maximum employment without a recession. So far, that hasn’t worked.

Sweet said there’s still a small chance of this kind of “soft landing,” but a six- to nine-month recession with a modest rise in unemployment and small GDP decline is more likely.

“We think this is going to be a very mild recession,” Sweet said.

What does this mean for the average household?

“You will see a rise in unemployment…but it’s still gonna be very low from a historical perspective,” according to Sweet’s predictions. “You’re gonna see weaker wage growth…we’ll see consumer delinquencies rise, but they’re still just normalizing from the pandemic.”

While a recession might not be exciting, it is better than the alternative, Bostic said in November.

“If high inflation persists for too long and becomes entrenched in the economy, we know that more prolonged and deeper economic pain will ensue,” Bostic said. “So, while there are risks that our policy actions to tame inflation could induce a recession, that would be preferred to the alternative.”

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