Banking Failures Prompt Fed To Reconsider Major March Hike

The failure of two of the largest thirty U.S. banks by assets in the past three days may temporarily moderate the Fed’s recently hawkish posture on interest rates. In testimony last week, Federal Reserve Chair Jerome Powell was hinting at a relatively large 0.5 percentage point hike at the Fed’s March 22 rate decision. Now interest rate futures imply a likelihood of a smaller 0.25 percentage point hike with a small chance of holding rates steady. Of course, markets and the Fed are still digesting recent news and policy responses.

Inflation Concerns

Regardless of disruption in the banking sector, inflation data remains a concern. With January’s CPI data showing spiking inflation, which February’s data could reinforce. Also, service inflation remains stubbornly high. Lack of sustained progress on inflation has caused the Fed to signal that more work in raising rates is needed.

Banking Risks

However, clearly sharply rising interest rates and the corresponding weakness in fixed income pricing is pressuring banks’ balance sheets. Fixed income assets, which are generally perceived as low risk, have seen relatively extreme declines in value over the past year as the Fed have hiked rates aggressively from very low levels.

That was one factor leading to the failure of Silicon Valley Bank and today Signature Bank closed too. Last week, the smaller crypto-focused Silvergate Bank also went into liquidation. The scale of bank failures in terms of total assets for 2023 is now similar in size to 2008 at the peak of the financial crisis. However, in 2008 a much larger number of individual banks failed.

As the Fed nears what is likely the top of the interest rate cycle, they have talked about the importance of risk management. It appears that the issues in the banking sector and the Treasury’s creation of a new $25 billion Bank Term Funding Program are sufficiently material that the Fed may want to take some time to gauge the market impact and the ripple effects, with the Fed’s rate decision under two weeks away.

March Decision

After teeing up the prospect of a larger March hike before recent banking collapses, the Fed may chose to act less aggressively. The events in the banking sector over recent days are significant.

The Fed’s aggressive interest rate hikes have put pressure on the banking sector, as well as other parts of the economy, such as housing. In part, that is how monetary policy operates, but the Fed also seeks stability in the financial system in additional to its goals of full employment and low inflation.

After a roller coaster week for expectations for the Fed’s March meeting, the Fed may reconsider it plans, at least for the next meeting, and be understandably preoccupied by topics beyond simply managing inflation. However, small incremental rate increases into the Fed’s June or July meetings appear likely assuming the banking sector doesn’t see further major institutional failures and assuming a deal is struck on the debt ceiling, which represents another small, but potentially very material risk to the U.S. economy.