The Fed’s new constraint: controlling inflation while preventing financial chaos

The chaos in the banking sector has led to calls on the Federal Reserve to suspend or even reverse its pace of monetary policy tightening. Economic data for February, meanwhile, showed that the labor market remains strong and inflation remains pervasive, underscoring the work that still needs to be done by the central bank to rein in price growth.

The challenge for the Fed is to figure out how to strengthen the banks and calm inflation at the same time, without triggering a recession. While the Fed could theoretically pursue a two-track approach, the risk is that continued interest rate hikes will further weigh on an already weakened financial sector.

“Their job has become much more complicated,” says Mark Zandi, chief economist at Moody’s Analytics.

The case for a pause in monetary policy tightening hinges on fears that recent bank failures and heightened recession expectations will pull back consumer and business spending, at least marginally, and that the The Fed is waiting to see if its emergency equity lending has succeeded in eradicating the banking turmoil before it raises rates further.

Some economists are also warning that the collapse of two regional banks risks making banks less eager to lend, thus tightening credit conditions and part of the Fed’s job to slow the economy. Goldman Sachs economists estimated on Wednesday that the “gradual tightening of lending standards” they anticipate due to continued strains on smaller banks would have the same effect as about 25 to 50 basis points, or 0.25 to 0.50 percentage point, interest rate increases.

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But banking turmoil does not happen in a vacuum. This is happening as inflation remains well above the Fed’s 2% target and is even accelerating by some measures. Although the financial volatility urges caution, economic data released since it began continues to suggest that further rate hikes are needed.

February Consumer Price Index data, released on Tuesday, showed core consumer prices rose 0.5% in the month. Retail sales data released Wednesday showed underlying strength in core control sales, which rose 0.5%. And on Thursday, new jobless claims fell while housing starts rose. Both exceeded expectations and confirmed that economic resilience persists.

The European Central Bank also went ahead on Thursday with plans it had made before the banking chaos began and raised interest rates by half a point. His action suggests that at least some central bankers believe they can continue to tighten monetary policy and fight inflation while navigating new uncertainty and working to stabilize the financial sector.

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Everything of which means the Fed cannot abandon its fight against inflation, even as it addresses the issue of the financial stability of regional banks, economists say. And that means the Fed must raise interest rates by a quarter point at its next meeting, despite last week’s chaos.

“The thing that’s still true here, even though we have a lot of news coming, is that inflation is still very much rooted in these sticky categories in the service sector that are really hard to eradicate,” says Thomas Simons, an economist at Jefferies. “If the Fed were to take a break here, I’m very concerned that inflation expectations will pick up again.”

For the Fed, suspending its monetary policy tightening campaign now would go against Chairman Jerome Powell’s promise that the central bank will not give up its fight for price stability until inflation subsides. not on the way back to the 2% target, economists say. Forgoing a raise could send the message that the central bank is not yet convinced that it has done enough to restore financial stability.

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Additionally, if a pause is interpreted as a sign that the Fed is done with raising rates, it could contribute to the idea that the runaway price growth is here to stay. This, in turn, may lead to a change in consumer behavior that ultimately makes it more difficult to slow inflation to 2%.

“The strongest argument for continuing to rise at the meeting a week from now is, if they don’t, then markets are going to ask, ‘Is this the end of Fed rate hikes?’ “Said Andrew Hollenhorst, Chief U.S. Economist at Citi. “If this is the end of Fed rate hikes, then inflation is still too high and the economy still appears to be overheated. we believe that inflation will drop to 2%?

What the Fed will do remains uncertain, especially since the decision is still almost a week away. But investors have started to buy into the idea of ​​a quarter-point rate hike, with data from CME tool FedWatch Thursday afternoon showing more than an 80% chance of a rise of that magnitude.

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Traders were spooked by the recent turmoil and stock markets plunged on Wednesday before paring most of their losses. But economists say the collapse of Silicon Valley Bank hasn’t changed their view of the economy much. While some economists who have spoken with barrons said risks are now more heavily tilted to the downside and that a recession could potentially come a little earlier than expected, none made major changes to its growth outlook or predicted an imminent collapse.

Instead, they mostly viewed the disruptions in the banking sector – at least for now – as more of an isolated weakness than a symbol of widespread economic calamity.

“Although highly uncertain, given the speed with which events are unfolding, the impact of bank failures on the economic outlook is expected to be marginal,” Zandi wrote this week. “The economy will struggle this year and next, and will remain vulnerable to events like those of the past few days, but this banking crisis is unlikely to be what will push the economy into recession.”

Write to Megan Cassella at

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