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The Fed must not flinch

Mar 22,2023 - Last updated at Mar 22,2023

WASHINGTON, DC — Financial-market turmoil has clouded the outlook for US monetary policy, with many economists, investors, and financial institutions expecting that the Federal Reserve will not increase its policy interest rate at its meeting this week. But while the failures of Silicon Valley Bank (SVB) and Signature Bank are significant market events, they should not knock the Fed off course. Policymakers should hike the benchmark federal funds rate by at least 25 basis points this week. With signs on Monday that bank deposits had stabilised, a 50 bps increase would be even better.

Last month, the consumer price index registered 6 per cent inflation relative to the same month in 2022. Stripping out volatile food and energy prices found 5.5 per cent “core” inflation. Over the past three months, core CPI has increased at a 5.2 per cent annual rate, the fastest pace since October 2022.

Nearly two years of decades-high inflation has inured the policy debate to these eye-popping numbers. Six per cent CPI inflation is an emergency that needs to be addressed with aggressive action. It should take a lot more than temporary instability in the community banking sector for the Fed to deescalate its response.

Of course, a series of bank runs across the country would have been a different story. But we have enough information at this point to conclude that this scenario is unlikely to materialise. The banks that failed were unusual in important respects: SVB badly managed the risk from rising interest rates and had an unusually large share of uninsured deposits. Signature was unusually exposed to cryptocurrency markets. First Republic Bank, teetering on the brink of failure at the time of this writing, was caught in the wake. But overall, the banking system is healthy, well capitalised, and profitable.

The aggressive response by the Treasury, the Fed, and the FDIC will forestall contagion that leads to broader bank runs and financial instability. Banks need liquidity at substantially heightened levels, and the Fed is meeting that need, primarily through the discount window. The system is working, with the most recent reports showing that deposit outflows from the most vulnerable banks were slowing, and in some cases reversing.

Meanwhile, consumer prices are rising, consumer demand is hot, and the labour market is very tight. Underlying inflation is running at more than double the Fed’s 2 per cent target rate. Inflation-adjusted consumer spending increased by 1.1 per cent in January, the largest monthly increase since March 2021 (and a 14.5 per cent annual rate).

Over the three-month period ending in February, employers added an average of 351,000 jobs per month, the fastest pace since September 2022. True, unemployment and workforce participation rates ticked up in February, and average wages ticked down. But wage growth — 4.6 per cent year on year and an annual rate of 3.6 per cent over the three previous months — remains faster than is consistent with the Fed’s inflation target.

Strange as it may seem, turmoil in the banking sector makes the Fed’s job easier by reducing the availability of credit to households and businesses and by tightening broader financial conditions. But the extent to which recent events will destroy demand is hard to determine. Will businesses defer spending? Will households cut back? (Goldman Sachs has just lowered its forecast for annual GDP growth in the fourth quarter of this year by 0.3 percentage points, owing to tighter lending standards.)

Given an overheated labour market and 1970s-like inflation, if the Fed cannot see the whites of the eyes of a systemic banking crisis, then it needs to move forward aggressively on bringing aggregate demand and supply back into balance. Easing up on the brake now would signal insufficiently strong resolve and raise concerns that uncertainty about the financial system now dominates monetary policy.

Moreover, easing up now would likely increase the risks facing financial markets over the medium term. The longer the Fed takes to get inflation under control, the greater the likelihood that inflation becomes further embedded in the labour market and in worker, household and investor expectations of future inflation. The more embedded inflation becomes, the harder it will be for the Fed to return it to target, and the greater the likelihood of a recession.

Recall that it was the Fed’s long delay in recognising that inflation wasn’t transitory that forced it to increase the federal funds rate by 450 bps in less than one year. That rapid pace of increases is in some part responsible for last week’s turmoil in the banking sector.

Beyond this week’s Fed meeting, tighter financial conditions might reduce the terminal federal funds rate. But the terminal rate was likely around 6 per cent before SVB failed. The Fed still has some way to go. A lower terminal rate is no reason to avoid a 25 or 50 bps increase at this week’s meeting.

By raising rates this week, the Fed has the opportunity to send two important signals: first, that it has confidence in the stability of the financial system, and, second, that its resolve in fighting inflation is unshakable.

The Fed should not miss the opportunity to communicate those messages to businesses, households, investors, and fiscal policymakers.


Michael R. Strain, director of Economic Policy Studies at the American Enterprise Institute, is the author, most recently, of “The American Dream Is Not Dead: (But Populism Could Kill It)” (Templeton Press, 2020). Copyright: Project Syndicate, 2023.

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