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New Fed News agency: Banking crisis puts Fed 'between a Rock and a Hard Place'
What is the Fed's choice in the face of still-high US inflation and the turmoil in financial markets brought on by Silicon Valley banks?
Nick Timiraos of the Wall Street Journal, dubbed the "new Fed wire service," argues in a recent article that the simultaneous problems of financial market stability and inflation and the side effects of aggressive rate hikes are coming "too fast and too fast," leaving the Fed in a bind. Timiraos explains:
On several occasions over the past year, Fed officials have acknowledged future risks to both financial stability and inflation. But aside from a sharp slowdown in the housing market, the Fed's aggressive moves to raise interest rates have had no noticeable side effects on the economy or the financial system.
However, the overnight insolvency of Silicon Valley Bank is forcing investors to rethink the future of regional banks, which could see many companies cut back sharply on lending because of high interest rates.
Timiraos noted that last week, Fed Chairman Jerome Powell's "double hawkish remarks" and lingering inflation and jobs data had made a 50 basis point March rate hike "a certainty."
But the storm at Silicon Valley banks has reversed everything, with market expectations for peak ECB rates falling below 3.5 per cent on Monday, less than 14 basis points for a Fed rate hike next week and even a 50 basis point cut by the end of the year.
According to the latest data from the Chicago Mercantile Exchange's FedWatch, the probability of the Fed not raising rates in March was 35 percent, up from zero a day earlier. The probability of a quarter-point rise is 65 per cent, compared with 90 per cent a month ago; The odds of a 50-basis-point increase have fallen to zero, from as high as 70 per cent before Silicon Valley banks collapsed.
The side effects of aggressive Fed rate hikes could get out of hand
Timiraos argues that the side effects of the Fed's efforts to cool demand by tightening financial conditions to fight inflation won't come too soon, but when they do they may get out of control:
It can be similar to pouring ketchup from a glass bottle: repeatedly tapping the bottle fruitlessly and then inadvertently pouring out too much ketchup.
A significant widening in credit spreads would make it more expensive for banks and companies to borrow, which could lead to a sharp pullback in lending -- too fast and too fast for the Fed.
Despite the Federal Reserve's emergency efforts to stabilize financial markets, financial conditions in the United States have tightened sharply and the overall financial system remains strained.
Michael Feroli, chief U.S. economist at jpmorgan, wrote in a Sunday night note that while the Fed wants to tighten financial conditions to curb aggregate demand, they do not want the effects of policy to spread quickly and get out of control, which would undoubtedly be detrimental to taxpayers.
How this crisis will unfold is unclear, according to Timiraos, but analysts warned on Monday that it could lead to more fundamental changes in the way the U.S. banking system operates:
If banks' uninsured transaction deposits continue to fall, credit could fall back, further hurting the prospects of small and medium-sized enterprises.
Fredric E. Russell Investment Management Co. Fredric Russell, chief executive of Fredric Russell, thinks this may simply be the "first cockroach in the kitchen" : banks descended into the darkness of complacency and then lowered their quality standards.
What is the Fed's choice
Timiraos notes that the Fed could take the U.S. back to the era of low interest rates and quantitative easing, as it did during the 2008 financial crisis, but core inflation, which strips out food and energy prices, is much higher now than it was then, posing a tougher test for Fed policy going forward:
If the Fed becomes more moderate in its fight against inflation, it could delay the kind of relief that markets suffered in 1998 after the Fed cut interest rates in response to the collapse of hedge fund Long-Term Capital Management.
Diane Swonk, U.S. economic adviser and chief economist at KPMG, noted that the immediate priority is to ensure the stability of the U.S. banking sector, and that if the Fed's actions ease financial market conditions, they may ease some inflationary pressures:
The only thing that could derail Fed tightening would be a financial crisis, and it's still too early to tell if that has been averted. The ultimate priority now is to make sure the banking sector is healthy and stable. But if these measures ease financial market conditions, you don't know how much you will reduce inflationary pressures.
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