Fed faces a nearly impossible task: Keep inflation fighting cred and financial stability

Published Tue, Mar 21 202312:19 PM EDTUpdated Tue, Mar 21 20231:27 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Some investors worry the Federal Reserve will have a tough time succeeding in wielding the tools to both fight inflation and calm the banking system. The Fed began its two-day meeting Tuesday morning, and it's widely expected to raise interest rates again. The futures market is pricing a more than 80% chance the central bank increases interest rates Wednesday by a quarter point. At the same time, the Fed has been using its balance sheet and other tools to help steady the banking sector since the failure of Silicon Valley Bank. The Fed is in a tricky spot. During the financial crisis and again in the Covid pandemic , it was able to come to the rescue of the financial system by cutting interest rates to zero. Now, it faces persistently high inflation and is considering another rate hike — a tool that could calm rising prices but add more pain to the banking system. The fed funds rate range is currently at 4.5% to 4.75%, rising from a zero to 0.25% range in just a year. "Very unfortunately, we don't believe that the FOMC has any good options available. If they hike, they risk further financial instability," writes Wolfe Research. "If they stand pat, they'll fall even further behind the curve on inflation — which is the root cause of current problems!" Citigroup strategists had similar concerns about the actions of central banks more broadly. "The idea that monetary authorities can neatly fight inflation and monetary instability at the same time with different tools is unlikely to work well," they wrote in a note. Inflation is also crippling to the economy. Rising prices for good and services eat away at households' savings and forces businesses to look for cost savings. Goldman Sachs economists are among the few who expect the Fed to refrain from hiking Wednesday because of worries about the banking system. "While policymakers have responded aggressively to shore up the financial system, markets appear to be less than fully convinced that efforts to support small and midsize banks will prove sufficient," they wrote. "We think Fed officials will therefore share our view that stress in the banking system remains the most immediate concern for now." Federal regulators helped backstop depositors at the failed Silicon Valley Bank and Signature Bank this month. The Fed has also provided lending for banks for up to a year on more generous terms. Ethan Harris, who heads Bank of America's global economic research, wrote in a note he has been surprised how "shock-free" the Fed's hiking cycle has been — up until recently. "In the summer of last year they shifted to one of the fastest hiking cycles in history. Given this shift, and the simple law of large numbers, it seemed surprising how uneventful the Fed's tightening cycle had been ... until a week or so ago," he wrote. "Indeed, part of our baseline view had been that some further tightening of financial conditions—and a mild recession—was likely needed to get inflation back to target."