THE FED´S JOB JUST GOT A WHOLE MORE COMPLICATED / BARRON´S MAGAZINE

The Fed’s Job Just Got a Whole Lot More Complicated

By Megan Cassella

Illustration by Lynne Carty / Barron’s; Bloomberg (1); Dreamstime (2)

The chaos in the banking sector has led to calls for the Federal Reserve to pause or even reverse its pace of monetary policy tightening. 

February’s economic data, meanwhile, show that the labor market remains strong and that inflation remains pervasive, underscoring how much work the central bank still has left to do to tame price growth.

The challenge for the Fed is figuring out how to buttress banks and cool inflation at the same time, without triggering a recession. 

While the Fed can theoretically pursue a dual-track approach, the risk is that continuing to raise interest rates will further strain an already weakening financial sector.

“Their job just got significantly more complicated,” says Mark Zandi, chief economist with Moody’s Analytics.

The arguments in favor of a pause in monetary-policy tightening center on fears that recent bank failures and heightened recession expectations will lead to a pullback in consumer and business spending, at least marginally, and that the Fed should wait to see whether its emergency lending actions have successfully stamped out banking turmoil before it raises rates further.

Some economists warn, too, that the collapse of two regional banks is likely to make banks less eager to lend, thereby tightening credit conditions and doing some of the Fed’s work of slowing the economy. 

Goldman Sachs economists on Wednesday estimated that the “incremental tightening in lending standards” they expect as a result of ongoing small-bank stress would have the same effect as roughly 25 to 50 basis points, or 0.25 to 0.50 percentage points, of interest-rate increases.

But the banking turmoil isn’t happening in a vacuum. 

It is taking place as inflation remains well above the Fed’s 2% target and is even accelerating by some measures. 

While financial volatility is reason to be cautious, the economic data released since it began continue to suggest that further rate hikes are needed.

February’s consumer price index data, released on Tuesday, showed core consumer prices gaining 0.5% over the month. 

Retail sales data released on Wednesday showed underlying strength in core control sales, which climbed 0.5%. 

And on Thursday, new applications for unemployment insurance fell while housing starts rose. 

Both exceeded expectations and confirmed that economic resilience persists.

The European Central Bank also moved ahead on Thursday with plans it had laid out before the banking chaos began, and raised interest rates by a half-point. 

Its action suggests that at least some central bankers feel they can continue to tighten monetary policy and tackle inflation while still navigating fresh uncertainty and working to stabilize the financial sector.

All of which means the Fed can’t abandon its inflation fight, even as it addresses the issue of financial stability among regional banks, economists say. 

And that means the Fed needs to raise interest rates by a quarter-point at its next meeting, despite the chaos of the past week.

“The thing that is still true here, even though we have a lot of news coming in, is that inflation is still very much rooted in these sticky service-sector categories that are just really tough to stamp out,” says Thomas Simons, an economist with Jefferies. 

“If the Fed were to pause here, I’m very concerned inflation expectations would take off higher once again.”

For the Fed, pausing its monetary-policy tightening campaign now would run against Chairman Jerome Powell’s pledge that the central bank won’t abandon its fight for price stability until inflation is well on its way back to the 2% target, economists say. 

Forgoing an increase could send a message that the central bank isn’t yet convinced it has done enough to restore financial stability.

What’s more, if a pause is interpreted as a sign that the Fed is done raising rates, it could contribute to a view that rampant price growth is here to stay. 

That, in turn, can cause a shift in consumer behavior that ultimately makes it more difficult to slow inflation back to 2%.

“The strongest argument for continuing to hike at the meeting a week from now is, if they don’t do that, then markets are going to ask, ‘Is this the end of Fed rate hikes?’ ” says Andrew Hollenhorst, chief U.S. economist with Citi. 

“If it’s the end of Fed rate hikes, then inflation is still too high and the economy still looks overheated. 

So then, why should there be confidence that inflation is going to come down to 2%?”

What the Fed will do remains unclear, not least because the decision is still nearly a week away. 

But investors have begun to come around to the idea of a quarter-point rate hike, with data from the CME FedWatch tool showing a more than 80% chance on Thursday afternoon of an increase of that size.

Traders have been spooked by the recent turmoil, and equity markets plunged on Wednesday before paring most of their losses. 

But economists say the collapse of Silicon Valley Bank hasn’t greatly shifted their views on the economy. 

While some economists who spoke with Barron’s said risks are now more heavily weighted to the downside, and that a recession could potentially come slightly sooner than had previously been anticipated, none had made major changes to their growth outlooks or were forecasting imminent collapse.

Instead, they mostly viewed disruptions in the banking sector—at least for now—as more isolated weakness than a symbol of broad-based economic calamity.

“While highly uncertain, given how quickly events are unfolding, the impact of the bank failures on the economic outlook should be on the margin,” Zandi wrote this week. 

“The economy will struggle this year and next, and will remain vulnerable to events like those of the past several days, but this banking crisis likely isn’t what will push the economy into recession.”