The bank panic worries investors.  Will the Fed make things worse?

The bank panic worries investors. Will the Fed make things worse?

  • Finance
  • March 17, 2023
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The flash collapse of three banks and the rescue of a fourth from the financial industry have put the spotlight on next week’s Federal Reserve decision on whether to raise interest rates further.

Just two weeks after Fed Chair Jerome Powell hinted that rates could hike even higher than previously forecast to quell inflation, many analysts are expecting a hike of no more than 0.25 percentage point, while some pundits are skeptical about policy Urging policymakers to hold the line for fear of further unsettling the banking system.

The dilemma underscores the multiple and conflicting problems facing the Fed. With key sectors of the economy strong and inflation still more than double the Fed’s target rate of 2%, the central bank is keenly aware that any sign it is slowing down in the fight against inflation will mean another wave of price hikes could trigger.

At the same time, the Federal Funds Rate hike could now magnify the kind of problems at other lenders that caused panicked depositors to pull their money out of Silicon Valley Bank.

“A financial disaster has happened and we’re going from no landing to a hard landing,” Torsten Slok, chief economist at private equity firm Apollo Global Management, said in a note this week predicting the Fed would keep interest rates on hold will hold when the officials meet 21.-22. March.

Kathy Bostjancic, chief economist at Nationwide, also believes the current strain on the country’s banking system could make Fed officials think twice about raising rates next week.

“Many people, even myself, were surprised that the Fed hiked rates by 10 percent [4.5 percentage] Points in 11 months and nothing has broken. It finally confirms the view that the Fed cannot hike rates anytime soon without something happening,” she told CBS MoneyWatch.

The Treasury Problem

While the SVB failed in part due to financial missteps, analysts have noted that rising interest rates played a crucial role in its collapse. Inundated with customer deposits during the pandemic, the bank grew rapidly, investing much of those funds in long-dated government and mortgage securities.

But when the Fed hiked interest rates, SVB assets fell in value. This kept the bank short of deposits as customers, spooked by SVB’s potential losses, rushed to withdraw their money. The concern now is that this pattern could be repeated at other banks that are ill-prepared for further rate hikes.

“We also see fear of balance sheet problems at regional banks,” said Bostjancic. “There is definitely evidence that since banks have received this huge inflow of deposits, they have invested a significant amount in government bonds. There are other banks that face this problem.”

Some customers of small and regional banks are already moving their funds to the largest institutions, Financial Times correspondent Stephen Gandel told CBS News.

Big banks see influx of new depositors after SVB collapse 05:59

Did the Fed Wreak This Havoc?

What led to the rapid growth in deposits at the SVB in the first place? More Americans went cashless in the early years of the pandemic as the tech industry experienced explosive growth. According to economists, both factors have been fueled by the government’s response to the COVID-19 crisis: hosing consumers and businesses with cash while keeping interest rates at zero for many months after the initial crisis ended in 2020.

The danger now is that the Fed, which has stepped on the gas too hard to keep the economy going in recent years, is now stepping on the brakes and risking a crash.

“Like the poor fool, the Federal Reserve overreacted to the inflationary cold spell during the COVID crisis by easing financial conditions too far for too long,” Gavekal Research’s Will Denyer wrote in a note this week. “The risk now is that the Fed has turned the lever too far in the other direction…tightening conditions so much that it has started a disinflationary process that will overshoot to the downside and likely cause a recession.”

tightening of financial conditions

The Fed’s primary tool for controlling inflation is to use its benchmark overnight lending rate to slow the economy. However, many economists say inflation is now cooling enough on its own without requiring additional help from the Fed, especially given the lag between monetary policy and economic growth. The current turmoil in banking and financial markets will also make lenders far more cautious and further contain inflationary pressures.

“In the future, banks, particularly small and medium-sized banks, are likely to significantly tighten their lending standards,” Nationwide’s Bostjancic predicted. “Fed officials need to keep in mind that more cautious bank lending will be an additional drag on economic activity, and that could be significant.”

Former FDIC Chair Sheila Bair on turmoil in the banking sector 06:15

In contrast, the Fed may very well decide that it has done enough to prop up the banking system after the collapse of SVB and New York’s Signature Bank and continue to hike interest rates. Following these failures, the Fed created a new lending program that effectively insures other banks’ Treasury holdings against losses for up to a year. The central bank may choose to keep interest rates on hold as a sign of confidence in its policies and its relentless commitment to lower inflation.

“What decision signals that they are still cautious about inflation and believe in the stability of the banking system? What message shows stability and confidence?” asked Ed Mills, Washington-based analyst at Raymond James. “I think the Fed looks good to have a week to digest this.”

“The banking industry is working on confidence as much as it is capital, and the banking industry is very well capitalized at this point,” Mills added. “But there’s a real question about trust.”

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