Fed to either pause or hike rates by 25 basis points: the pros and cons of each

The Fed’s meeting this week is different because it follows the sudden collapse of confidence in the U.S. banking system following the government takeover of Silicon Valley Bank as well as the tremors around the world that have led to the shotgun wedding of Swiss banking giant Credit Suisse and its longtime rival, UBS.

At the moment, the market probabilities are 73% for a quarter-percentage-point move and 27% for no move, according to the CME FedWatch tool. The market seems to be growing in confidence of a hike, analysts said, based on movements on the front end of the curve.

The Fed’s decision will come on Wednesday at 2 p.m. Eastern and will be followed by a press conference from Fed Chair Jerome Powell.

“Depending on your perspective, the Fed’s decision will be seen as either capitulation to the markets or ivory-tower isolation from the markets,” said Ian Katz, a financial sector analyst with Capital Alpha Partners.

Here are the pros and cons for both a pause and a 25-basis-point hike.

The case for and against a pause

The main rationale for a pause is that the banking system is under stress.

“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. We think Fed officials will therefore share our view that stress in the banking system remains the most immediate concern for now,” said Jan Hatzius, chief economist at Goldman Sachs, in a note to clients Monday morning.

Former New York Fed President William Dudley said he would recommend a pause. “The case for zero is ‘do no harm,’” he said.

The case against a pause is that it could spark more worries about the banking system.

“I think if they pause, they are going to have to explain exactly what they are seeing, what is giving them more concern. I am not sure a pause is comforting,” said former Fed Vice Chair Roger Ferguson in a television interview on Monday

The case for and against a 25-basis-point hike

The main reason for a quarter-percentage-point rate increase, to a range of 4.75%-5%, is that it could project confidence.

“What you need from policymakers is steady hands, steady ship,” said Max Kettner, chief multi-asset strategist at HSBC. “You don’t need overaction … flip-flopping around in projections or opinions.”

The Fed should say that it has managed to contain confidence so far and that “we can press ahead with the inflation fight,” he added.

Oren Klachkin, lead U.S. economist at Oxford Economics, said he didn’t think “the recent bank failures pose systemic risks to the broad financial system and economy.”

He noted that “inflation is still running hot” and the Fed has better ways to alleviate banking-sector stress than interest rates.

The case against hiking is that doing so could further exacerbate concerns about the stability of the banking sector.

“A rate hike now might have to be quickly reversed to deal with a deeper, less contained recession and disinflation. Why would the Fed raise rates when it may be forced to cut rates so much sooner than previously hoped?” asked Diane Swonk, chief economist at KPMG.

Gregory Daco, chief economist at EY, said he thinks economic activity is slowing, which gives the Fed time.

“There is no rush to hike. We are not going to see hyperinflation as a result,” he said.

Stocks
DJIA,
+1.20%

SPX,
+0.89%
rose Monday. The yield on the 10-year Treasury note
TMUBMUSD10Y,
3.485%
inched up to 3.46%, still well below the 4% level seen prior to the banking crisis.