Banks are running scared. Is the Federal Reserve about to make things worse?
The lightning collapse of three banks and financial industry rescue of a fourth has put a spotlight on the Federal Reserve’s decision next week over whether to continue raising interest rates.
Just two weeks after Fed Chair Jerome Powell suggested rates could rise even higher than previously projected in a bid to quash inflation, many analysts expect a no more than 0.25 percentage-point hike, while some experts are urging policy makers to hold the line for fear of further unsettling the banking system.
The quandary highlights the multiple, and conflicting, issues facing the Fed. With key sectors of the economy going strong and inflation still more than double the Fed’s target rate of 2%, the central bank is keenly aware that any sign it is relenting in the battle against inflation could give rise to another wave of price increases.
At the same time, lifting the federal funds rate now could magnify the kind of problems at other lenders that led panicked depositors to yank their money out of Silicon Valley Bank.
“A financial accident has happened, and we are going from no landing to a hard landing,” Torsten Slok, chief economist at private equity firm Apollo Global Management, said in a note this week that predicted the Fed will keep rates steady when officials meet March 21-22.
Kathy Bostjancic, chief economist at Nationwide, also thinks the current stress on the nation’s banking system could make Fed officials think twice about hiking rates next week.
“Many people, even myself, had been surprised that the Fed raised rates by [4.5 percentage] points in 11 months and nothing did break. It’s finally vindicating the view that the Fed can’t raise rates that fast without something happening,” she told CBS MoneyWatch.
The Treasury problem
While SVB failed partly because of financial missteps, analysts say rising interest rates played a critical role in its collapse. Flooded with customer deposits during the pandemic, the bank grew rapidly and put much of these funds into long-term Treasury bonds and mortgage securities.
But as the Fed jacked up rates, SVB’s investments lost value. That left the bank short on deposits just as customers spooked by SVB’s potential losses were rushing to withdraw their money. The concern now is that this pattern could repeat itself at other banks ill-prepared for further rate hikes.
“We’re also seeing fear of balance-sheet issues at regional banks,” Bostjancic said. “There’s definitely evidence that banks, as they’ve received this tremendous inflow of deposits, a significant amount went into Treasury securities. There are other banks that are facing that issue.”
Already, some customers at small and regional banks are moving their funds to the largest institutions, Financial Times correspondent Stephen Gandel told CBS News.
Did the Fed make this mess?
What led to SVB’s fast growth in deposits in the first place? More Americans were flush with cash in the early years of the pandemic, while the tech industry saw explosive growth. According to economists, both factors were fueled by the government’s response to the COVID-19 crisis: hosing consumers and businesses down with cash, while also keeping interest rates at zero for many months after the initial crisis in 2020 had passed.
The danger now is that the Fed, having stepped on the gas too hard in recent years to keep the economy motoring forward, is now stomping on the brakes and risking a crash.
“Like the poor fool, the U.S. Federal Reserve overreacted to the inflation cold spell during the COVID crisis by easing financial conditions too far for too long,” Will Denyer of Gavekal Research wrote in a note this week. “The risk now is that the Fed has cranked the handle too far the other way … tightening conditions so much that it has initiated a disinflationary process that will overshoot to the downside, likely causing a recession.”
Financial conditions tightening
The Fed’s main tool for controlling inflation is to use its benchmark overnight lending rate to slow the economy. But many economists say inflation is now cooling enough on its own without the need for additional help from the Fed, especially given the lag between monetary policy and economic growth. The current tumult in banking and in financial markets will also make lenders far more cautious, further containing inflationary pressures.
“Going forward banks, especially small and medium-sized banks, are likely to tighten their credit standards significantly,” Nationwide’s Bostjancic prediicted. “Fed officials need to consider that more cautious bank lending will be an additional brake on economic activity, and it could be significant.”
By contrast, the Fed could very well decide that it has done enough to shore up the banking system following the collapse of SVB and New York’s Signature Bank and continue pushing up interest rates. After those failures, the Fed created a new lending program effectively insuring other banks’ Treasury holdings against losses for up to a year.
The upshot: The central bank could choose to stay the course on rate hikes as a sign of confidence in its policy measures and of its unremitting commitment to lower inflation.
“What decision sends a message that they’re still cautious about inflation and believe in the stability of the banking system? What message portrays stability and confidence?” asked Ed Mills, Washington analyst at Raymond James. “I think the Fed is fine having another week to digest that.”
“The banking industry works on confidence as much as it works on capital, and the banking industry is very well-capitalized at this point,” Mills added. “But there is a real question about confidence.”
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