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Bank stocks rebound, but crisis makes the Fed’s next move harder

Inflation eased only slightly in February. Meanwhile, the collapse of two banks raised new fears that interest rates are rising too fast.

Customers at a flower shop on Valentine's Day in Atlanta. Bank failures are suddenly complicating the Federal Reserve's fight to control inflation, even though prices remain stubbornly high. (Dustin Chambers/Bloomberg News)
8 min

Days of panic over a potential banking crisis gave way to a tenuous calm Tuesday, as bank stocks rebounded sharply on hopes that new backstops for the financial system would be enough to stem a broader meltdown.

Still, the road ahead remains shaky. Concerns over an increasingly fragile financial system after two bank failures are complicating the Federal Reserve’s already rocky path to slowing the economy. The central bank is now weighing stubborn inflation readings — including new data released Tuesday — against jittery global capital markets in deciding how much higher interest rates can go when it meets next week.

The Justice Department and Securities and Exchange Commission are investigating Silicon Valley Bank’s collapse and the actions of its senior executives. And Moody’s on Tuesday downgraded its outlook on the entire U.S. banking system from “stable” to “negative,” citing a “rapid deterioration in the operating environment.”

The Fed’s fight against inflation just got downgraded

“There’s new optimism that we won’t have a full-blown crisis, but we can’t just go back to sleep like nothing happened,” said Itamar Drechsler, a finance professor at the University of Pennsylvania’s Wharton School. “Even though things aren’t irreparably broken, that doesn’t mean there aren’t more challenges ahead.”

The sudden and spectacular collapse of Silicon Valley Bank last week set off tremors of cascading runs at other U.S. banks after depositors withdrew a record $42 billion in just 24 hours from the California institution. In an emergency move over the weekend, federal regulators took sweeping steps to prop up deposits at SVB and Signature Bank of New York, another failed institution. But that wasn’t enough to immediately assuage investors’ fears: Shares of regional bank stocks plummeted by as much as 62 percent Monday.

By Tuesday, though, the mood had improved. All three major stock indexes rebounded, as bank shares made up for much of their losses from the day before. Even First Republic Bank, a midsize San Francisco bank that lost two-thirds of its stock value earlier in the week, managed to make up some of those losses. Its shares, which fell from $82 to $31 between Friday and Monday, were up to about $40 at Tuesday’s close.

“Initially the fear was that the SVB collapse, followed by a second bank failure on Sunday, would roll into something even bigger and more devastating,” said Pao-Lin Tien, an economics professor at George Washington University. “The good news is that we haven’t seen any further bank failures. The fact that things are calming down means we are managing the crisis well at this initial stage. Our policies are working.”

That newfound optimism, combined with new inflation figures released Tuesday, reignited debate over just how much higher the Fed might lift interest rates when it meets next week. The central bank has been rapidly raising borrowing costs for a year in hopes of slowing the economy enough to temper fast-rising prices. But now the bank failures, partly sparked by investments that went south as interest rates rose, have ratcheted up worries that the Fed has moved too fast.

Although inflation has eased from June highs of 9.1 percent, it remains too high for comfort. Prices rose 6 percent in February compared with a year earlier, according to new data released Tuesday by the Bureau of Labor Statistics. Higher housing costs weighed heavily on the latest figures, contributing to more than 70 percent of the monthly increase. Food, recreation and household furnishings also rose in price, though natural gas prices and other energy costs fell.

“Big picture, progress on taming inflation has been slower than we had imagined,” said Pooja Sriram, an economist at Barclays. But, she added, “for the Federal Reserve, risk management considerations are likely to take priority, at least for now.”

Banking experts said regulators’ recent effort to protect all deposits at SVB and Signature Bank, even those over the $250,000 limit for federal bank guarantees, raises broader questions about whether those protections would be extended to all uninsured deposits if other banks were to fail.

“Down the road the important job is to figure out what policy changes we can make to ensure we don’t end up encouraging banking institutions and depositors to take on unnecessary risks,” said Tien of George Washington University.

By many measures, the U.S. economy remains extraordinarily strong. Employment is high, workers are getting raises and people are continuing to spend briskly despite high inflation. But in recent months, there have also been troubling signs, including rising credit card balances and high-profile tech layoffs, that have led to growing fears that the country could tip into recession later this year.

The latest round of financial tumult intensified those concerns, even as policymakers sought to reassure Americans that their money was safe. President Biden doubled down on that message Tuesday, calling the recent bank failures a small blip in the United States’ path to a more solid economy.

“As I’ve long said, and as challenges in the banking sector remind us, there will be setbacks along the way in our transition to steady and stable growth,” Biden said in a statement. “But we face these challenges from a position of strength.”

In testimony to Congress on March 7, Federal Reserve Chair Jerome H. Powell suggested the central bank could keep raising interest rates. (Video: Reuters)

There are already signs that the Fed’s tightening is working, at least in some parts of the economy. The housing market has slowed, manufacturing is down and prices on a number of goods have stabilized. Washing machines, tires, smartphones, meat and whiskey all got cheaper in February, though economists say there is still a long way to go in bringing down “sticky” prices on services, such as rent, transportation and restaurants.

Housing prices have had a particularly outsize impact on inflation in recent months, in part because of how shelter costs are calculated in the U.S. consumer price index. There is often a lag of nine to 12 months before changes in rent prices show up in inflation data.

“We saw a tick back up in housing, but a lot of that is for methodological reasons,” said Andrew Patterson, senior international economist at Vanguard, referring to federal calculations that involve rental projections and not actual sales prices. “We believe housing is going to start to be a drag on inflation in the second half of the year, which should help the Fed.”

Still, he said, the latest report “further signals that the Fed has more work left to do.”

Moving at remarkable speed, the Fed has hiked its base policy rate from near zero to between 4.5 percent and 4.75 percent. Although analysts had previously expected the Fed to keep hiking rates until they settled between 5.5 percent and 6 percent, some are scrapping those projections to account for an immediate pause after the bank failures.

The collapse of Silicon Valley Bank is, in some ways, a byproduct of the aggressive efforts to raise borrowing costs after years of near-zero interest rates. For years, start-ups and tech firms benefited from easy access to cheap money. But as the Fed has rapidly raised borrowing costs, those firms have been among the first to take a hit.

Now Goldman Sachs this week said it no longer expects the Fed to raise interest rates at all in March “in light of recent stress in the banking system.” The bank’s economists say the central bank is likely to pick back up with quarter-point rate hikes in May, June and July, though they note there is “considerable uncertainty” ahead. Others, though, including Bank of America and Citigroup, are still forecasting a quarter-point interest rate increase, a step down from what many expected just last week, after Fed Chair Jerome H. Powell told Congress the central bank wouldn’t hesitate to raise rates faster than planned if the economy didn’t appear to be slowing rapidly enough.

Washington’s bank rescue fails to erase all doubts

That extra uncertainty is making some business owners nervous. Rami Tannous, who owns Hidden Hype Boutique, a men’s streetwear and sneaker store in San Jose, says shoppers have been pulling back for over a year. Higher rent and gas prices mean many are trading down to lower-priced goods or buying one pair of shoes instead of two.

Now, with the failure of nearby Silicon Valley Bank, he’s bracing for another round of cutbacks.

“There was a real panic over the weekend, but even with the [federal] guarantee of funds, I think people are still freaked out,” he said. “Uncertainty is a big problem for us.”

Aaron Gregg, Jacob Bogage and Devlin Barrett contributed to this report.