Status: 03/22/2023 06:01 a.m
In the wake of the recent banking turmoil, the Federal Reserve faces a tough decision: to keep raising interest rates or not? A pause in interest rates could, however, have consequences.
Small interest rate step or interest rate pause? That’s the question on the minds of the Fed and markets midweek. The central bankers around Fed Chair Jerome Powell are facing a difficult decision tonight. Finally, over the past few days, markets have felt the painful impact of what happens when the US Federal Reserve does what it takes to get inflation under control.
Small interest rate step as a compromise
According to CME Group’s Fed Watch Tool, 85 percent of market participants expect interest rates to rise by 0.25 percentage points. The key interest rate would rise accordingly to 5.0 percent. “The 25 basis points seem to be a good compromise for the markets,” explains Robert Rethfeld from Wellenreiter-Invest in an interview tagesschau.de. “I expect a small rate hike plus clear indications that the Fed is ready to take appropriate action if the banking crisis deepens.”
Franck Dixmier, head of bonds at Allianz Global Investors, also sees the US monetary authorities as having a duty: “The Fed must raise interest rates.” The US Federal Reserve cannot be satisfied with a core inflation rate of 5.5 percent.
Fed caught between banking crisis and fighting inflation
According to experts, an interest rate pause would also send out a fatal signal, since such a pause would have the potential to plunge the markets into turbulence all the more, because it would fuel fears among investors that the situation at US banks would be much worse is than previously expected.
“In the event of an interest rate pause, the markets would assume that the Fed is concentrating too much on the banking crisis and neglecting to fight inflation,” emphasizes Wellenreiter expert Rethfeld. That would damage the US Federal Reserve’s credibility. “At the same time, the Fed would send out a crisis signal, which of course they want to avoid at all costs.”
DWS economist Christian Scherrmann also warns that investors could take an interest rate pause or even a rate cut as a sign that the central banks are assuming major turmoil in the financial system.
Markets are pricing in recession
With the flare-up of the banking crisis in the USA, the monetary policy prospects for the remainder of the year are more uncertain than ever. Almost exactly a year ago, the Fed started its current interest rate hike cycle, raising the key interest rate from zero to 4.75 percent. There had never been such a sharp increase in interest rates within such a short period of time.
But the rate hike cycle could be coming to an end as early as today. “The markets are now pricing in the high interest rate at 5.0 percent and a drop in interest rates to 3.75 percent by mid-2024,” emphasizes Rethfeld. “The expectation of such a sharp rate cut heralds a recession.”
Alarm bells are ringing in the bond market
A look at the bond market still doesn’t bode well either: “The yield curve is currently more inverted than it has been since the 1970s,” says Rethfeld. Market experts speak of an inverted yield curve when the yield on two-year US government bonds is quoted above the yield on ten-year US bonds.
An inverted yield curve is considered a valid harbinger of a recession. According to a study by the Federal Reserve Bank of San Francisco, every economic downturn in the US since 1955 has been preceded by an inverted yield curve with one exception.
Rising risk of recession due to regional banks
To make matters worse, the problems at the US regional banks have what it takes to further fuel the risks of a recession, as Rethfeld tells us in an interview tagesschau.de explains: “The business of the regional banks consists primarily of granting loans. If fewer loans are granted because of the financial problems at the regional institutes, then economic activity falls.”
If the banks reduce their risks, this is tantamount to a significant increase in interest rates, comments Ben Laidler, market strategist at online broker eToro. “So the Fed’s job is done by other means.”
But there is a fine line between the desired dampening of inflation and the economy on the one hand and the negative consequences of an uncontrolled banking crisis. The regional banks must now be strengthened – be it through deposits from the big banks or through an expansion of deposit insurance, according to Wellenreiter expert Rethfeld, who warns: “Otherwise, given the lack of liquidity in the credit sector, there is a risk of a self-reinforcing downward spiral.”