The Federal Open Market Committee (FOMC) meets next week on Tuesday and Wednesday, March 21‒22. A week ago, investors were fretting over whether the FOMC might speed up its rate hikes. Now, some are saying the FOMC might cut rates. What’s changed in such a short time? Things are breaking, that’s what.
Today—March 16, 2023—is the one-year anniversary of the Federal Reserve’s (Fed’s) first rate hike to combat inflation. A lot has changed since then. The Great Inflation of 2022 is giving way to a Great Deceleration in economic activity. Although job gains—for now—have stayed robust, cracks are forming in the financial system, which could speed up disinflation and economic deceleration. Central banks have a history of hiking until something breaks. Are we past the point of no return as things seem to be falling apart?
With Silicon Valley Bank’s (SVB’s) collapse, we’ve seen the first bank failure since the Global Financial Crisis. SVB may have been an outlier in terms of its depositor base and its interest rate bets, but investors are still wondering how many other outliers might be out there. The Federal Deposit Insurance Corporation (FDIC) invoked a systemic risk exception in coordination with the Fed and the U.S. Treasury to insure all deposits. The Fed also created a new lending program for banks, called the Bank Term Funding Program. Financial strains aren’t just a U.S. phenomenon, though. In Switzerland, the Swiss National Bank has pledged to provide liquidity as needed to help one of its beleaguered institutions that’s a Global Systemically Important Bank (a regulatory designation).
Central banks are not at fault for the business decisions of failed banks. But, steps central banks have taken—the higher rates and quantitative tightening sucking bank reserves (and, by extension, deposits) out of the financial system—have created the cracks starting to form in the financial system. In 2022, the Fed’s furious pace of rate hikes broke the spirit of investors as bonds and stocks sold off in tandem. Housing, business investment, and manufacturing have been suffering under the weight of higher rates. Now, we have financial stresses turning into distress. Could this be a clarion call for the Fed to pause? Probably not.
The Fed and other central banks probably think they have big enough toolboxes to achieve multiple goals at once, even if those goals seem to be in conflict. The Fed may believe its rate hikes can, and should, be calibrated to deal with inflation while its various lending facilities are the right tools for the job of promoting financial stability.
One thing that may be hotly discussed at its upcoming FOMC meeting is whether the Fed’s program of quantitative tightening should slow or be put on pause for now. Quantitative tightening is designed to drain reserves from the banking system, which drains deposits as well. To the extent the recent financial strains have been caused by depositors taking flight, the Fed may need to rethink how fast it should shrink its balance sheet and over what timeframe.
However, it’s more likely that it will think its lending programs and the FDIC’s intervention are sufficient to promote financial stability and rebuild the public’s confidence in the health of the financial system. In fact, financial strains may be a feature rather than a bug of the Fed’s tightening program. By creating some financial strain, it could help “rebalance” the economy to lower inflation.
The Fed is stuck between a rock and a hard place, with inflation too high but financial stresses being intense. A Fed pause with a stern warning that rate hikes could restart after the financial dust settles can’t be ruled out. It’s more likely, though, that the Fed will just try to tread a bit more cautiously and maintain a slow pace of hikes, praying that things get better by its May meeting.
When the Fed is stuck in a pickle, investors are the ones who might feel the crunch. It’s in times of stress that some of the best opportunities can also present themselves. Patience, diversification, and working with top-notch investment managers can potentially make the journey more tolerable.
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