The Washington PostDemocracy Dies in Darkness

The Fed’s fight against inflation just got downgraded

In a sharp turnaround from last week, the central bank is largely expected to pause aggressive interest rate hikes as financial markets wobble

The exterior of the Federal Reserve Board building. (Alex Wong/Getty Images)
4 min

The Federal Reserve’s aggressive year-long fight against inflation has hit its first major roadblock with the collapse of two large banks that have cast a pall over the U.S. financial system.

The crisis, which has already prompted a large response from the Fed and other regulators in the form of a new special lending facility and measures to make depositors of the failed banks whole, is raising questions about whether the central bank can continue to hiking interest rates in the face of an increasingly fragile financial system.

“The Fed has now lost the luxury of being almost single-mindedly focused on the fight against inflation,” said Frances Donald, global chief economist and strategist for Manulife Investment Management. “There was always going to be an inflection point when the costs of the rate hikes outweighed the benefits. The Fed has to consider that we’re much closer to that moment than before.”

Live updates: Bank stocks slide despite U.S. government intervention

Wall Street, which until a few days ago expected the Fed to raise interest rates by another half-percentage point this month, has sharply revised down its forecasts. Goldman Sachs economists on Sunday said they no longer expect the Fed to increase borrowing costs in March “in light of recent stress in the banking system.”

Overall, markets are divided between a possible quarter-percentage hike or none at all at the central bank’s next meeting on March 22. The central bank’s decision will probably also hinge on two upcoming reports this week — the consumer price index on Tuesday and retail sales on Wednesday — that will offer an updated snapshot of inflation in the economy.

“If they raise rates next week, I would be absolutely speechless,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities America. “Just last week the Fed was alluding to have to raise rates even higher, but this is a whole new situation. SVB is exacerbating what had already been a looming problem: The Fed was singularly focused on inflation, not recognizing that it would be prudent to sit and wait and see how things evolve.”

Fed may need more aggressive interest rate hikes, Powell says

The likely U-turn comes less than a week after Fed Chair Jerome H. Powell told Congress he “would be prepared to increase the pace of rate hikes” if the job market and other parts of the economy remained resilient.

But the sudden failure and shutdown of Silicon Valley Bank on Friday, followed by sweeping measures by regulators to stem the fallout, is prompting larger questions about whether the Fed would keep raising interest rates even as it creates facilities to lessen the side effects of higher rates.

“We are in an environment where there is stress in the banking system, where the Fed, Treasury and FDIC have intervened and may need to intervene further,” said Gregory Daco, chief economist at EY. “But at the same time, the Fed and Fed Chair Powell do not want their legacy to be one where they lost the battle against inflation.”

Inflation has proved more stubborn than Fed officials expected, and job growth has continued to outpace even Wall Street’s most bullish forecasts, confounding the Fed’s efforts to dampen consumer and business demand and relieve price pressures throughout the economy.

Silicon Valley Bank failure raises fear of broader financial contagion

That means there’s still a case for further monetary tightening even in the face of shaky financial market confidence.

“Unless we go into a full-on financial meltdown, I think the Fed will still hike by 25 basis points next week,” said Megan Greene, global chief economist at Kroll Institute. “The Fed has tools for macro policy and it has tools for financial stability — and they’re different. Cutting interest rates or pausing them wouldn’t have much effect on the banking sector and would ultimately stoke inflation.”

Others, however, believe the distinction between the two will not be so clear-cut, forcing the Fed to rethink its strategy of tackling inflation with additional increases to borrowing costs.

Barclay’s, which last week expected an interest rate hike of a half-percentage point, has updated its stance to say it’s now leaning “toward zero.” But, bank economists noted, it’s likely the Fed will resume rate hikes this spring, after financial turmoil calms down.

“Based on the financial market turbulence over the weekend ...we believe that the most likely outcome will be a pause,” they wrote in a research note on Monday.

David J. Lynch contributed to this report.