Failing banks complicate the Fed’s task

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Credit Sesame looks at how failing banks complicate the Fed’s decision on how much to raise interest rates.

On March 22, the Federal Open Market Committee (FOMC) announced that it was raising the Fed funds rate by 0.25%. This small increase says a lot about the conflicting issues the Fed is juggling.

In the twelve months up to March 2023, the Fed’s rate decisions have been guided by the need to cool down inflation without choking off economic growth too severely. That’s a difficult balance to strike, The recent failures of several high-profile banks–and the fear of more to follow–make the Fed’s job even more complicated.

Higher rate hike expected before failing banks

In the run-up to the latest FOMC meeting, it was widely expected that the Fed would raise rates by 0.50%. By way of background, the Fed has raised rates steadily over the past year to tame inflation, with limited success.

The Personal Consumption Expenditures Price Index, the Fed’s preferred measure of inflation, gave an unexpectedly hot reading for January with a 0.6% increase. This indicated that inflation persists.

Meanwhile, the job market has stayed strong so far in 2023. The Fed has conceded that it’s prepared to put up with some job losses in its efforts to slow inflation, but so far that hasn’t happened.

Perhaps the most compelling reason to have expected a bigger rate increase from the Fed was because borrowing has continued to soar. Each new report shows consumer debt, particularly credit card debt, setting a new record high.

If the idea is that raising interest rates discourages borrowing and reduces the demand helping to drive inflation, it hasn’t worked so far.

In short, when March began the stage seemed set for the Fed to raise rates by 0.50% at the FOMC meeting. Then the bank failures hit.

Did previous rate hikes contribute to bank failures?

The failure of Signature Bank and Silicon Valley Bank raised concerns about whether other banks might follow. That threat is enough to make the Fed tread carefully. It must consider whether its monetary policy measures might disrupt the financial system.

That concern is especially understandable under the circumstances. There is a relationship between interest rate increases and the liquidity problems experienced by some banks.

How interest rates affect bank profitability

One reason banks are generally profitable is that they get to pay short-term interest rates to depositors while earning long-term rates on loans and investments. This normally works to their advantage because long-term interest rates are usually higher than short-term rates.

This model has broken down recently because of the rapid rise in interest rates.

The surge in short-term rates over the past year has caused an inverted yield curve. That’s economist-speak for saying that short-term rates are now higher than long-term rates.

An inverted yield curve erodes the normal profitability of the spread between long-term and short-term rates. Worse, much of the money banks earn is locked up in loans and investments at rates set before rates started rising. Meanwhile, most deposit rates reset frequently. This has made the rates banks earn even less competitive with the rates they pay depositors.

Is the Fed to blame for failing banks?

Under the circumstances, it is clear why the Fed may want to slow its rate increases. However, it is a mistake to blame the Fed for the predicament of some banks. Here’s why:

  • People incorrectly assume that the Fed has total control over interest rates. The fact is, when inflation rises, lenders and investors demand higher rates to cover the cost of inflation. Therefore, market rates rise regardless of what the Fed does.
  • In its public announcements and multi-year rate projections, the Fed has been very transparent about its intentions to raise rates. Financial professionals who did not see this situation coming and respond accordingly are perhaps more to blame than the Fed.

Projections suggest rates don’t have much further to rise

The FOMC updated the Fed’s rate projections at its most recent meetings and expects rates to rise to 5.1% by the end of 2023. That’s a little higher than the current target range of 4.75% to 5.0%. But that does not preclude the possibility of the Fed pushing rates higher in the next few months, with the hope of lowering them by the end of the year.

Note also, that projections are subject to revision. While the Fed did not raise its rate projection in the recent meeting, it did increase its estimate of year-end inflation.

Normally, a higher rate expectation would go hand-in-hand with a higher inflation expectation. In this case, it’s entirely possible that the Fed held off on raising its projection to avoid disrupting the banking sector at a sensitive time.

What does this mean for the fight against inflation?

Despite the milder-than-expected rate hike, the FOMC’s statement after its last meeting reiterated that it is strongly committed to bringing inflation down to its 2% target.

Banking instability adds a wild card to that challenge. The Fed already walked a tightrope between dampening borrowing demand and avoiding a recession. The Fed’s updated projections show weaker growth and stronger inflation than previously expected. This underscores how tough that balancing act is. Now the FOMC has to focus on how much its rate hikes might jeopardize the banking sector.

Ironically, recent bank problems might assist with the goal of slowing consumer borrowing. When banks have balance sheet concerns they become more cautious about lending. Fewer consumers qualifying for borrowing might do what raising interest rates has so far failed to do.

Between higher interest rates and stricter lending standards, consumers may have to get used to borrowing less.

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

Richard Barrington
Financial analyst for Credit Sesame, Richard Barrington earned his Chartered Financial Analyst designation and worked for over thirty years in the financial industry. He graduated from St. John Fisher College and joined Manning & Napier Advisors. He worked his way up to become head of marketing and client service, an owner of the firm and a member of its governing executive committee. He left the investment business in 2006 to become a financial analyst and commentator with a focus on the impact of the economy on personal finances. In that role he has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications.

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