‘Ice close to thin’: Looming credit crunch puts pressure on Fed

When Jay Powell answered questions from reporters on Wednesday following the US Federal Reserve’s decision to go ahead with another interest rate hike, he joked that it had been “a very interesting seven weeks.”

Fed chairman spoke after the bank higher rates by a quarter of a point and signaled that he may be nearing the end of his campaign to root out inflation after the most aggressive monetary tightening campaign in decades.

The cessation of the painful increase in frequency would normally be an occasion for relief, even celebration, but there is one inconvenient fact: the reason why fed thinks it can afford to die down is the worst bout of banking turmoil since the great financial crisis of 2008, and critics of the US central bank say it should have been foreseen.

“They’re afraid they’re approaching thin ice,” Diane Swank, chief economist at KPMG, said of the predicament the Fed is facing. Now he must decide whether to continue to slow down the economy, or the looming credit crunch caused by the collapse of Silicon Valley Bank and Signature Bank will do the job for him.

“They want to bring down inflation without sending the economy into a deep freeze, which is very difficult to do,” Swank added.

Powell rightly so, the US central bank has been on a rollercoaster ride for the past two months or so, as have investors and traders hanging on its every word.

At the close of the Fed’s February meeting, Powell seemed optimistic that the central bank had turned the corner on inflation and that a “soft landing”—where price pressure eases without a painful recession—is in the offing.

This quickly gave way to fears that the economy was picking up again. Just two weeks ago, Powell even floated the idea that the Fed could abandon the gradual quarter-point rate hike it opted for in February and return to a half-point hike this month. He also warned that the Fed may have to tighten policy more than expected to bring inflation back to the 2 percent target set by the central bank.

Now that militancy has evaporated thanks to the collapse of SVB and Signature. Indeed, on Wednesday, Powell acknowledged that the Fed was considering pausing — meaning not raising rates altogether — this month.

The collapse and government takeover of two lenders has stressed the banking industry, especially for smaller operators, prompting a series of emergency measures from the Fed and other parts of the US government to prevent further spread of the infection.

It’s not clear if politicians have done enough as bank shares, already in depression, sold off again on Wednesday after Janet Yellen, the treasury secretary, ruled out general guarantees in the near term for more than $250,000 in deposits.

Economists warn that the turmoil could lead to exactly the same kind of credit crunch that the Fed hoped to trigger by tightening monetary policy, although the central bank has much less influence over it.

“We are still in a situation where financial conditions need to tighten in order for inflation to come down,” Swank said. “But what’s tricky at the moment is that the Fed doesn’t have as much control as it once thought. He has lost some of his ability to determine the path.”

Benson Durham, head of global policy at Piper Sandler and a former senior Fed official, said: “They always wanted to tighten financial conditions, but tighten in an orderly manner. Bank raids are a messy way.”

In a statement on Wednesday, the Federal Open Market Committee said the banking turmoil “is likely to tighten credit conditions for households and businesses and impact economic activity, employment and inflation.” “The extent of these effects is unclear,” he warned.

Powell argued this at a press conference on Wednesday. “This tightening of financial conditions will work in the same direction as tightening rates,” he said, adding that it could potentially be the equivalent of “a rate hike or possibly more.”

“Of course, today it is not possible to give such an estimate with any precision,” he warned.

Most Fed officials still believe the federal funds rate will peak between 5 percent and 5.25 percent this year, a quarter point above the level reached after Wednesday’s rate hike, according to a new set of economic forecasts known as the dot plot. . This has not changed from the December forecast.

In a sign that the FOMC may be nearing the end of its rate hike campaign, the policy statement said “some additional policy tightening may be appropriate.” Powell urged journalists to focus on the “some” and “may” in the phrase, though he was adamant that no rate cuts were expected this year.

Ellen Zentner, Morgan Stanley’s chief US economist, said the difficult economic background means Powell was right to send a “very vague, very soft” signal. “The Fed is not making any promises here,” she added.

Tom Porcelli, chief US economist at RBC Capital Markets, found a clearer message: “the recovery cycle is over.” “In terms of action, it screams that they are aware of the seriousness of the moment.”

Given the turmoil in the banking sector, it may not come as a surprise that the Fed has slightly lowered its forecast for an economy that is expected to grow by just 0.4% this year and then expand by 1.2% in 2024. Such sluggish growth is a daunting prospect for the president. Joe Biden, who said he plans to run for re-election next year.

The unemployment rate is projected to peak at 4.6% in 2024, according to most policymakers, as core inflation eases to 2.6%, still above the target.

Although Powell argued that the “pathway” for a soft landing still existed, he acknowledged that it had become narrower in light of recent events.

Durham puts the chance of a recession at about 35 percent, but in the event of a larger shock to financial conditions, that chance rises to more than 60 percent. “The distribution of where things go is just very broad,” he added.

More pressure on the Fed at an already difficult time comes from the criticism it has drawn for failing in its role as watchdog and regulator of the SVB. On Wednesday, the Bank of England announced that warned about the rising risks in SVB long before it collapsed.

Rule changes enacted in 2019 under Powell’s leadership that led to lighter regulation of smaller banks are also being questioned.

The first sign of a bipartisan consensus that the Fed had made a mistake was when two senators who couldn’t be further apart in political circles introduced legislation that would replace the central bank’s internal investigator with a president-designate.

“After the Federal Reserve failed to properly identify and prevent the shocking failures of Silicon Valley Bank and Signature Bank, it became clear that we could no longer wait for big changes at the Fed,” said Rick Scott, a Florida Republican who Supported by Democrat Elizabeth Warren.

“When a bank fails, there are investigations, and of course we welcome that,” Powell said.