3 Things the Fed Might Do Now

While the sale of Credit Suisse to UBS may have assuaged some fears about the international banking system, there are still numerous weaknesses that the past few weeks have highlighted. In the US, nearly 200 banks are reputed to be at risk of failure, and confidence in the banking system is slowly eroding. The Federal Reserve System has come in for criticism from Sen. Elizabeth Warren (D-MA) and others who allege that the Fed’s interest rate hikes have been responsible for this turmoil in the banking system.

In a way that’s true, because the Fed’s interest rate hikes have resulted in a fall in bond prices, eliminating the value of much of the Tier 1 capital banks hold. But in a way it’s not the Fed’s fault, because banks are supposed to be taking scenarios like this into account when they’re deciding how much of a capital buffer they need to hold. The stress tests banks have been held accountable for should have included situations like today in which interest rates are far higher than zero, so banks should have been prepared for this.

Still, the Fed is going to have to take the current banking crisis into consideration when the Federal Open Market Committee (FOMC) meets this week. And we can’t rule out the possibility that the Fed may change course due to the recent upheaval. Here are three things the Fed might do.

1. Continue Hiking

The odds of aggressive Fed rate hikes seem to have decreased since the events of the past few weeks, but most analysts are still expecting at least a 25 basis point rate hike at this week’s FOMC meeting. You may have missed the latest inflation data since it came out right in the middle of all this bank hoopla, but it’s still at 6% year on year, not exactly what the Fed wants to see right now.

Like it or not, the Fed has an inflation problem, and it has signaled that it will do whatever it takes in order to get inflation back under control. With the establishment of the Bank Term Funding Program (BTFP) to help out troubled banks, the Fed undoubtedly thinks that it has managed to paper over the current crisis, just as it thought it did in 2007-08 and onward. So the green light is likely still on for another hike this week.

2. Pause Hikes

While a rate hike pause likely won’t happen this week, if banks remain in trouble over the next few weeks, the May FOMC meeting could see a pause in hiking. Things that could likely result in a pause include:

1. a significant increase in discount window lending (currently at $153 billion as of March 15th), which would indicate ongoing weakness in the banking sector;
2. a significant drop in the inflation rate, e.g. the CPI release on April 12th reading 5.2% or less year on year; or
3. continuing bank failures.

A pause in hikes wouldn’t necessarily be permanent, it could just be something the Fed uses to reassess the financial climate and determine its path going forward. But doing so would send major shockwaves through the economy and would likely bring up questions about the Fed’s plans going forward.

Markets have been hoping for rate cuts for months, and keep getting those hopes dashed. It seemed as though the Fed was going to continue to raise rates and keep them elevated at least through the end of the year, but the recent weakness in the banking sector may have thrown that into doubt.

3. Expand Lending Facilities

The BTFP is only $25 billion, a drop in the bucket compared both to the uninsured deposits at Silicon Valley Bank (SVB) and Signature Bank and to the amount of money the Fed is already loaning out, which sits at over $318 billion as of March 15th. Its purpose seems to have been more to assuage the public or Wall Street that banks would be taken care of, rather than to actually support the entire banking sector.

But the Fed could certainly expand the size of the BTFP, especially if a large bank or systemically significant bank were to get into trouble. Had the BTFP been in operation when SVB was experiencing its difficulties, the bank likely never would have had to sell its securities at a loss. It could have lent those securities to the Fed at par, rather than sell them at market value, in order to redeem deposit withdrawals, and the problems it experienced in trying to raise extra capital wouldn’t have occurred.

The Fed likely hopes that the BTFP will aid the banking sector, but isn’t necessarily preparing for any sort of massive assistance to bail out banks. Still, given the Fed’s history in assisting banks and financial institutions throughout the 2008 crisis and beyond, don’t expect the BTFP to be the only way the Fed responds to the banking crisis. We could very well see significantly expanded Fed lending to the financial sector if continued weakness in the banking sector remains.

The Impact on Your Finances

With inflation having affected millions of American households over the past few years, you’re undoubtedly aware of the impact that the Fed’s monetary policy has on your pocketbook. But if the weakness in the banking sector grows, the risk of further Fed involvement in bailing out troubled banks will likely grow as well.

While the Fed has been slowly trying to unwind its balance sheet, and inflation has been slowly falling as money supply growth has stagnated, the past week has seen the Fed’s balance sheet suddenly shoot up as the Fed has had to intervene in order to stabilize the banking sector. Half of the Fed’s balance sheet reduction was undone in a single week, and further efforts to assist banks could end up seeing the balance sheet rise even further.

The inflationary impacts of this can’t be underestimated. And while the Fed may still end up committed to hiking interest rates, doing so at the same time as its balance sheet is increasing may not result in an effective effort to bring down inflation.

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