Avert banking crisis or tackle inflationUS Fed has a tough choice to make next week

By India Today Business DeskIn just six days, the US Federal Reserve will have to make an important decision on whether it will hike interest rates or pause for the time being.

The central bank of the most powerful economy in the world faces a dilemma after two private lenders collapsed suddenly last week, sending shockwaves across global markets.

What is the US Fed’s dilemma?

Over the past year, the US Federal Reserve has hiked interest rates aggressively to reduce inflation after two years of the pandemic.

The Fed was expected to hike rates again in its upcoming March policy review, but analysts are not sure about such a possibility anymore in the wake of the banking turmoil since last week.

The ongoing banking crisis has emerged as a real-time challenge for US Fed Chair Jerome Powell and his colleagues, who will be torn between reducing inflation – which still remains high – and coming to the rescue of the banking system.

Analysts on US Fed’s tough task

Goldman Sachs analysts recently predicted that the Fed may skip hiking interest rates in March due to the current situation.

In fact, the yield on the 2-year Treasury note, which is among the top traded securities in the world and also a proxy for Fed policy expectations, fell by more than half a percentage point. This was the biggest fall since Black Monday in October 1987, reported news agency Reuters.

Though the note recovered on Tuesday, it again fell on Wednesday, signalling high volatility.

Just last week, Jerome Powell indicated that the central bank could accelerate its rate hiking cycle to tackle persistently high inflation. Traders had already factored in the possibility of a 50 basis point hike after that.

However, the banking crisis that started over the weekend with SVB’s collapse has changed everything.

Traders now expect a smaller 25 basis point hike or a pause from the Fed in its March policy and some even expect it to cut rates in future policy review to avert a full-blown banking crisis that could cripple the US economy.

But a complete pause in a rate hike may not be on the cards, given the slow progression in the Fed’s fight against inflation.

Jefferies analyst Thomas Simmons told Reuters that the Fed is likely to hike interest rates by 25 bps next week.

“They need to keep up the fight on inflation to maintain credibility, and a pause here at these levels isn’t going to stop the bleeding in the markets,” he added.

Simmons added that a pause could risk undoing the work of the Fed’s 4.5 per cent points of rate hikes since March.

Meanwhile, former Boston Fed President Eric Rosengren had a completely opposite view amid the banking crisis.

“Financial crises create demand destruction,” Rosengren said on Twitter.

“Banks reduce credit availability, consumers hold off large purchases, businesses defer spending. Interest rates should pause until the degree of demand destruction can be evaluated,” he added.

But there is another problemuncertainty. The banking turmoil that gripped the US and most global markets was sudden, though not completely out of the blue.

Analysts are also unsure of how swiftly and deeply the current turmoil in the banking sector would impact the real economy.

While interest rate hikes are designed to slow down the economy and rein in inflation, in this case banks have come under pressure. Commenting on the recent bank failures, JP Morgan’s Michael Feroli wrote“We’re getting a better sense of who’s suffered due to the Fed’s aggressive tightening.”

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He also predicted that slower growth in lending by mid-sized banks will sheer off halt to a percentage point of economic growth overall, and it is “broadly consistent” with the view that higher interest rates will trigger a US recession that will slow inflation.

“A pause now would send the wrong signal about the seriousness of the Fed’s inflation resolve,” Feroli said.

The US Federal Reserve is all set to publish new projections for the future path of the US benchmark rate next week. Most traders expect at least one more interest rate hike, following which there could be a string of reductions.

“The Fed has a very difficult policy decision to make at next week’s meeting,” Paul Ashworth, chief North America economist at Capital Economics, told Reuters.

“It is a very close call… the risk of a full-blown contagion remains, and a lot can happen in the week until the announcement,” he added.

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Brewing banking crisis

The banking crisis started with the collapse of California-based lender Silicon Valley Bank, a unit of SVB Financial Group. It was the second biggest banking failure in US history. Just a couple of days later, another New York-based lender, Signature Bank, was shuttered by authorities.

US authorities, including the US Federal Reserve, rushed to announce a host of emergency measures to limit the impact of the brewing crisis. This helped restore confidence in the banking system, only to be shaken again a couple of days later.

Just when the global markets were gaining momentum after positive US inflation data, it was trouble in paradise once again.

Top European lender Credit Suisse AG Group, a leading global investment bank, saw its shares tank up to 30 per cent after its biggest backer Saudi National Bank reportedly denied providing it additional support. It started off a fresh bloodbath in global banking and financial stocks, and some smaller US banks again came under pressure.

While the Swiss National Bank quickly came to the aid of Credit Suisse and provided it a $54 billion lifeline, sentiments around banking stocks soured globally.

As a result, another US lender, First Republic Bank (FRB), is heading in the same direction as SVB. FRB’s stock has tanked nearly 70 per cent in the last five trading sessions, and over 20 per cent in overnight trade.

A Bloomberg report indicates that it is exploring all options, including a potential sale, to avert the sudden liquidity crisis after two global ratings agencies, S&P and Fitch, downgraded it.

Experts believe that there could be more pain for several US banks, especially small and mid-sized ones who are sitting on a pile of losses as the era of easy money came to an end last year.

Some feel that the failure of the two banks till now is just the “tip of the iceberg” and more consolidation awaits the banks in the world’s most powerful economy.