Fed’s battle plan for inflation shattered by financial turmoil

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(Bloomberg) — Federal Reserve Chairman Jerome Powell’s strategy to ramp up the central bank’s efforts to fight inflation is unfolding in the wake of the Silicon Valley bank collapse.

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A week ago, Powell surprised markets by saying the Fed may need to raise interest rates at a faster pace than the quarter-point increase in February to prevent persistent inflation. Days later, SVB and Bank failed, and the Treasury and Fed launched a massive emergency lending facility saying more banks faced the risk of runs.

The turmoil in markets on Monday suggested widespread fears about financial instability – and the risk the US economy could slide into recession. Two-year Treasury yields were about half a percent lower as investors bet the Fed would scale back rate hikes and perhaps halt its year-old tightening campaign altogether. Bank shares again declined, although the broader market was in the green by afternoon.

Worryingly, the collapse of SVB and Bank is just the beginning of a long of casualties from the Fed’s shift to higher rates since policymakers began slashing borrowing costs in 2007.

While Powell used his testimony to signal some chance of a half-point rate hike at the March 21-22 policy meeting, the latest upheaval – a risk that Fed staff once again missed – is a matter of concern for the policy committee. Will force a rewrite of the playbook.

Given market pressure to hold off on any further moves, some policymakers may argue for maintaining the more moderate pace of growth adopted in February. Laurie Logan, Dallas Fed president who previously ran the markets division at the New York Fed — making him the most market-savvy of the Fed’s top officials — called for a more measured approach to rate hikes, after last year’s quick ramp up Continually argued.

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Logan, who votes on rates this year, said in his first monetary policy speech in January, “Slow is one way to make sure we make the best possible decisions.”

Some hawks on the committee will point to the new lending facility as a stabilizing force that allows the Fed to go with half-point moves. A still-strong labor market, and possibly a hot inflation report coming Tuesday, could support any argument for raising the pace by 50 basis points.

disputed mission

Futures suggest the immediate is whether to move further, and bets are on a rate cut later in the year. Goldman Sachs Group Inc. Now predicts the Fed will stand pat next week, and economists at Barclays Plc said “we’re leaning towards that call”.

“This is the first time in this cycle that there has been a conflict within their mandate,” said Mark Sumerlin, founder of Evenflow Macro in Washington. “Central banks were set up for financial stability and they obviously react to this, so now they are asking themselves to be confronted with financial stability and inflation asking them to tighten further.”

The chair told Congress that despite a quarter-point increase in February, policymakers would be quick to push rates higher and lower prices.

A few days later, SVB and Bank failed, and the Treasury and the Fed launched a massive emergency lending facility, saying that more banks were at risk.

flip flop

With bank stocks falling again on Monday, any move by the Fed to stick to the pre-SVB collapse narrative could spark August 2007 comparisons. Even as markets began to show signs of concern about subprime mortgage securities, the Fed insisted that inflation had topped out. Worry A few days later, it cut the rate at which banks lend money.

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The central bank has had several more pivots recently. That was forced to change in late 2021 when inflation was said to be “fleeting”, much stickier than policy makers and economists had initially predicted.

Criticism is now emerging that Powell’s message last week was not conducive to risk build-up in the financial system.

Dario Perkins, an economist at TS Lombard who previously worked at the Treasury, said in a tweet on Monday, “Central banks have become a source of macro volatility rather than a frustration.”

risk of inflation

Still, Tuesday’s inflation data may remind Fed watchers and investors alike that the policymakers’ mission is not accomplished.

“These events will provide further caution, but must be balanced against the new worsening inflation picture,” economists at LH Mayer/Monetary Policy Analytics wrote in a note to clients. “While the likelihood of a March hike has decreased by 50 basis points, we believe the Committee will still end up hiking.”

Ironically, the financial disruptions began just weeks after the departure of Fed Vice Chairman Lael Brainard, who led the central bank’s efforts to tighten financial regulation – ultimately unsuccessfully – and oversee the cumulative effect of monetary tightening. Highlighted the importance. Powell helped ensure a lax approach to regulation.

Recent events shed light on Powell’s management of monetary policy over the past 12 months.

bet off

With inflation galloping, the committee began raising rates from zero with a quarter-point move a year ago, followed by a of four 75-basis-point moves before increasing the pace by 50 basis points. The policymakers then went up to 50 in December and 25 in February.

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But relatively warm readings for January on inflation and the labor market, as well as an upward revision in prior data, prompted Powell to leave the door open for an increase in momentum. This prompted some Fed watchers to change their calls, and futures markets began to price in a high probability of a 50-basis-point move.

On Monday, those bets were off.

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