Fed’s dilemma over rate rises complicated by strong inflation

The Federal Reserve’s dilemma over whether to press ahead with its campaign of raising interest rates after bank failures has been further complicated by the release of strong inflation data.

Officials of the US central bank are set to gather next week for a two-day policy meeting at which they will decide how substantially to alter their plans for monetary tightening in light of the turmoil in the banking system triggered by last week’s implosion of Silicon Valley Bank, which was followed by that of Signature Bank.

But following the release of data on Tuesday showing a 0.5 per cent rise in “core” consumer price growth in February despite a slower annual pace, the Fed must now thread a delicate needle of continuing to root out persistent inflation while also ensuring the smooth functioning of the financial system.

“They’re stuck between their inflation objectives and their financial stability objectives, and that’s really what they’re evaluating here,” said Nathan Sheets, global head of international economics at Citigroup and a former US Treasury official.

In the days before SVB’s collapse, which forced the Fed and other government authorities to intervene to limit contagion, chair Jay Powell had floated the idea that the central bank might consider reverting to half-point rate rises, as data showed renewed strength in the labour market and rebounding consumer spending.

That followed a historic, months-long campaign of supersized rate rises intended to tame rampant price pressures, which the Fed had only wound back down to a more typical quarter-point pace in February.

At the time, Powell said forthcoming data — including Tuesday’s inflation report and the latest jobs report, which showed employers added a robust 311,000 positions in February — would be closely scrutinised before a decision was made.

But economists say the collapse of SVB has fundamentally changed the policy outlook, muddying the central bank’s path forward and raising concerns over the level of interest rates the financial system can withstand.

Late on Sunday, economists at Goldman Sachs switched their expectations from a quarter-point increase in March to no rate rise at all, noting “considerable uncertainty about the path beyond” that point.

Julian Richers, an economist at Morgan Stanley, said “uncertainty had blown up” in the aftermath of the bank failures, and the Fed would be “attentive” to further signs of stress.

February’s inflation report has complicated the picture further. Over the past three months, “core” consumer price growth — which strips out volatile food and energy prices and homes in on services-related costs — has increased at a 5.2 per cent annualised rate, the highest reading since October 2022.

“In the absence of what’s happening in financial markets, this is the type of data that likely would have motivated a 50 basis point rate hike next week,” said Matthew Luzzetti, chief US economist at Deutsche Bank.

While he described the inflation data as “unrelenting”, Luzzetti said he expects the Fed to proceed with a quarter-point rate rise this month and signal that the federal funds rate will peak just above 5 per cent.

Richers added the CPI figures meant officials should not stop rate rises altogether, even in light of the SVB fallout. “There certainly seem to be concerns about market functioning, but it’s not something that a pause will necessarily ease,” he said.

Economists say the Fed must also contend with broader questions of how financial instability stemming from SVB’s failure will effect demand and economic activity.

Speaking with the Financial Times on Friday — following the jobs report and SVB’s collapse — Thomas Barkin, president of the Richmond Fed, said he was chiefly focused on demand in determining the future of the central bank’s tightening campaign, adding this was an area in which financial stability “may or may not have an impact”.

“Even if the Fed is to stem this and we see no other bank failures, there’s been tightening in credit conditions [and] there’s been tightening in financial conditions,” said Priya Misra, head of global rates strategy at TD Securities, adding that this could lead to an “earlier recession or a deeper one” than previously expected.

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