Caught Between Inflation And Banking Turmoil, Fed Opts For A Small Hike

As expected, the Federal Reserve (the Fed) raised interest rates by a quarter of a percentage point on Wednesday, taking its key federal funds rate to a range of 4.75%-5% – the highest since August 2007. That came as a relief to some investors, given that Fed Chair Jerome Powell had earlier this month opened the door to reaccelerating the pace of rate hikes back to half-point increases – but three US bank failures since then unsurprisingly threw cold water on the plan. Equally, the rate decision probably disappointed other investors who were hoping for the Fed to pause or even cut interest rates on the back of the recent turmoil in the banking sector.

To be fair to the Fed, there were no easy options this time round. A pause could’ve signaled that it’s not confident in the resiliency of the banking system or the economy, or that it sees problems that aren’t yet visible to the rest of us. On the other hand, a hike could still add to the stress caused by troubles in the banking sector and lead to further market volatility down the road. In an extreme scenario, the financial sector’s woes could spiral into a credit crunch that triggers a recession. The Fed so far doesn’t think that’ll happen. In new language added to the central bank’s statement, it said that the US banking system is “sound and resilient”, though it did warn that recent developments are likely to result in tighter credit conditions for households and businesses, and could weigh on economic activity.

Now, while this entire discussion has so far been centered on the impact of interest rates on financial stability, investors shouldn’t ignore the 1,000-ton elephant in the room: price stability. Inflation is still triple the Fed’s 2% target, despite the central bank’s most aggressive rate-hiking campaign in decades. Trouble is, above-target inflation has a tendency to remain stubbornly high, and the Fed’s well-aware of the history of the 1970s when insufficient rate hikes helped to entrench outsized price gains.

So what’s the future path of interest rates in light of all of this? Well, the Fed has a tough job ahead as it treads a fine line between combating inflation and preventing an all-out banking crisis. Its latest "dot plot", released alongside its rate decision, shows Fed officials still project interest rates to end 2023 at 5.1% – similar to what they were forecasting back in December. That’s surprisingly low, considering that traders were betting that the Fed would raise its key rate to as high as 5.7% just a few weeks ago. That was after Powell delivered a warning about higher rates – but, crucially, before the troubles at Silicon Valley Bank surfaced.