Fed’s Looming Rate Decision Could Confirm Crisis At Hand—Or Trigger A Worse-Than-Feared Recession

Topline

Ahead of a pivotal interest rate decision on Wednesday, the Federal Reserve faces a novel dilemma: stubbornly high inflation amid massive uncertainty over a banking crisis that could force a preemptive hiking pause—a prospect some analysts fear could make a potential recession worse than previously feared.

U.S. Federal Reserve Chair Jerome Powell testifies at a hearing before the United States Senate … [+] Committee on March 7.

Key Facts

For the first time during the post-pandemic recovery, the outlook for the Fed and the U.S. economy has become two-sided, Bank of America economist Michael Gapen wrote in a Friday note to clients, reiterating the risk that the Fed could hike more than expected to cool stubbornly high inflation, but adding there’s now a greater risk the Fed could pause or lower rates sooner.

For now, Gapen’s team still expects a mild recession beginning in the third quarter, but as financial stress emerges in the form of regional bank struggles, a shock in the system could mean a “harder landing for the economy,” the economists warn.

“In light of the banking crisis, a recession is even more likely—and might be pulled forward,” says CIBC Private Wealth investment chief David Donabedian, who notes the Fed still wants to raise rates “a bit more” to help cool inflation but now faces “a close call” between taming prices and risking a worsening crisis.

In a Thursday note, Moody’s analyst Jill Cetina pointed out borrowing from the Fed’s discount window (known as a last resort for banks in need of cash) jumped to $153 billion from $5 billion last week—a sharp spike in emergency borrowing that “speaks to the funding and liquidity strains on banks”; the ratings agency changed its outlook for the banking system to negative on Monday.

Some are more optimistic: UBS’ Erika Najarian says liquidity issues in the banking system “don’t appear widespread,” citing the Fed’s new funding program for banks, unveiled over the weekend, has picked up only $12 billion in loans through Wednesday—a sign fears may be overblown.

What We Don’t Know

It’s still unclear how Fed officials will react to the banking sector’s struggles, but some clarity will come on Wednesday, when the Fed concludes its next policy meeting and announces how high it will raise interest rates—or whether it will do so at all. Before the crisis of the past week, many experts predicted the Fed may accelerate the pace of rate hikes—authorizing a half-point increase after a quarter-point hike last month. After SVB’s collapse, analysts at Goldman Sachs said they “no longer expect” the Fed to hike rates this month. Others, including investment bank Nomura, followed suit, calling for no increase. But Bank of America still expects a quarter-point hike.

Crucial Quote

“The risk of not raising rates next week is that everyone knows the Fed was planning a rate hike,” says Donabedian. “Foregoing a rate hike [could indicate] the Fed is confirming that a crisis is at hand.”

What To Watch For

If the banking industry’s troubles get worse, the Fed has options: After the 1987 stock market crash and the collapse of a highly leveraged hedge fund in 1998, the central bank pivoted from fighting inflation to stabilizing the financial system—cutting rates to help markets recover before ultimately returning to its aggressive hiking agenda.

Tangent

Donabedian believes a likely recession will be the “market-clearing event” that helps start a new bull market. “This is normally the case,” he says. “In the last 10 recessions, the stock market bottomed on average 4 months before the recession ended. Nine of those ten examples proved to be the beginning of a new, durable bull market.”