The Federal Reserve must choose between inflation and market chaos

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“Our policy actions work through financial conditions.” So said Jerome Powell, chairman of the Federal Reserve, the end of last year, referring to the causal chain of monetary policy. As interest rates rise, tighter financial conditions prompt companies and consumers to cut spending, fueling an economic downturn and low inflation. The past ten days have painted a less desirable causal chain: from high rates to a banking crisis,

These stormy financial conditions pose a dilemma for the Fed. Should it focus on higher inflation, and thus keep raising rates? or is financial stability priority now?

Policymakers will take a decision the regular monetary-policy meeting on March 22. before the turmoil that started with a walk on silicon valley bank, a ninth straight hike appears to be a foregone conclusion. The debate was whether the Fed would opt for a quarter-point increase or a half-point increase like in January. Now there is uncertainty about whether it will raise rates or not. Market pricing specifies prospects for a quarter-point hike of about 60% and a 40% Fed stay – not far from a coin flip.

The case for a stay rests on two arguments. First, high rates are the root of financial chaos. Even though the Silicon Valley bank was an outlier in its missteps, other banks and financial firms, from hedge funds to insurers, suffer huge mark-to-market losses on their bond holdings. A further hike in rates could widen their notional deficit.

Second, volatility itself is a drag on the economy. As trust crumbles, companies try to preserve capital. Banks lend less and investors withdraw. Measures of financial conditions – including interest rates, credit spreads and stock prices – tightened sharply over the past ten days. Eric Rosengren, former chairman of the Fed’s Boston branch, compared it to the aftermath of an earthquake. Before resuming normal life, it is prudent to see whether there are aftershocks and whether buildings are structurally sound. The same logic applies to monetary policy following a financial shock. “Go slow, check for other problems,” Mr. Rosengren cautioned.

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Proponents of going ahead with hikes acknowledge that financial instability is a form of tightening. But they see it as an argument for a quarter point increase instead of the half point that many had supported. Persisting with rate hikes now would signal that the Fed is still intent on tamping down inflation, which is too high for comfort, as evidenced by the 6% year-over-year increase in consumer prices in February. The flicker of recovery in the property industry indicates that, unlike poorly run banks, most of the economy can tolerate higher rates.

A hike would also demonstrate that the Fed can chew gum and run the same time. In an ideal world the authorities should be able to manage financial stability while keeping inflation under control. With a combination of deposit guarantees, a new liquidity facility and support from big banks, a framework is now in place to shore up America’s financial institutions.


The size of the expansion on the Fed’s balance sheet reveals the scale of support. Banks borrowed about $153bn from the Fed’s discount window in the week to 15 March, down from $5bn in the previous week, as well as $11.9bn from the central bank’s new liquidity facility. This has eased the selloff in the markets, least for now, which may prompt the Fed to turn its attention back to inflation. Indeed, it can look to the example of the European Central Bank, which announced a half-point hike on March 16 despite financial chaos.

Then there is the question of market psychology – even more important in times of panic. Intuitively, a hike can be somewhat reassuring. A pause suggests that the Fed, in its dovish tone and action for the past year, is indeed worried. Conversely, an increase would signal that it feels the crisis is under control.

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Numerically, the difference between the options is small. The Fed is expected to either keep its target for short-term rates in a range between 4.5% and 4.75%, or raise it to between 4.75% and 5%. From a purely financial point of view, it is almost immaterial. In terms of policy, this could hardly be more important.

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