Fed Raises Rates but Nods to Greater Uncertainty After Banking Stress
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Fed Raises Rates but Nods to Greater Uncertainty After Banking Stress

Officials voted unanimously to increase their benchmark short-term rate by a quarter percentage point

By NICK TIMIRAOS
Thu, Mar 23, 2023 9:07amGrey Clock 5 min

The Federal Reserve approved another quarter-percentage-point interest-rate increase but signalled that banking-system turmoil might end its rate-rise campaign sooner than seemed likely two weeks ago.

The decision Wednesday marked the Fed’s ninth consecutive rate increase aimed at battling inflation over the past year. It will bring its benchmark federal-funds rate to a range between 4.75% and 5%, the highest level since September 2007.

Officials sent a hint that they might be done raising interest rates soon in their post meeting policy statement. “The committee anticipates that some additional policy firming may be appropriate,” the statement said. Officials dropped a phrase used in their previous eight statements that said the committee anticipated “ongoing increases” in rates would be appropriate.

The policy statement said it was too soon to tell how much recent banking stress would slow the economy. “The U.S. banking system is sound and resilient,” the statement said. “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”

All 11 voters on the rate-setting Federal Open Market Committee agreed to the decision.

New projections showed 17 out of 18 officials who participated in the meeting expect the fed-funds rate to rise to at least 5.1% and to stay there through December, implying one more quarter-point increase. The quarterly projections were little changed from those released in December.

Fed officials have at times over the past year acknowledged the risk of being forced to simultaneously fight two problems—financial instability and inflation. Several have said they would use emergency lending tools, along the lines of those unveiled this month, to stabilise credit markets so they could continue to raise interest rates or hold rates at higher levels to combat inflation.

At a news conference after the decision, Fed Chair Jerome Powell said officials had considered holding rates steady but opted to raise them given signs of still-high inflation and economic activity.

Various estimates of how much the banking stress could slow the economy amount to “guesswork, almost, at this point,” Mr. Powell said. “But we think it’s potentially quite real. And that argues for being alert as we go forward.”

That turmoil offers the strongest evidence yet of spillovers from higher interest rates to the broader economy. The upheaval has served as a stiff reminder of the perils Fed officials, regulators, lawmakers and the White House face trying to corral inflation that soared to a 40-year high last year.

U.S. policy makers cushioned the economic shock created by the Covid-19 pandemic in 2020 and 2021 by providing extensive financial aid and cheap money. Congress and the White House have largely delegated to the Fed the task of taming price pressures.

The fed-funds rate influences other borrowing costs throughout the economy, including rates on mortgages, credit cards and auto loans. The Fed has been raising rates to cool inflation by slowing economic growth. It believes those policy moves work through markets by tightening financial conditions, such as by raising borrowing costs or lowering prices of stocks and other assets.

Two weeks ago, Mr. Powell suggested officials would debate whether to raise rates by a quarter-point or a bigger half-point after reports showed hiring, spending and inflation were stronger early this year than they thought at the time of their Jan. 31-Feb. 1 meeting. “Nothing about the data suggests to me that we’ve tightened too much,” he said on March 7 before the Senate Banking Committee.

An astonishing run on the $200 billion Silicon Valley Bank changed everything. SVB’s depositors were heavily concentrated in the tight knit world of venture capital and startup firms, which were burning cash and withdrawing deposits as the once-highflying technology sector cooled.

On March 8, SVB said it was looking to raise capital from investors and that it would record a loss on longer-dated securities whose values had fallen as interest rates shot up. Nearly a quarter of the bank’s deposits fled over the next day and the bank was taken over by regulators on March 10.

To avoid a broader panic, federal authorities guaranteed the uninsured deposits of the California lender and a second institution, New York’s Signature Bank. The Fed also began offering loans of up to one year to banks on more generous terms as a precaution.

Banking-sector tremors are likely to lead to a pullback in lending because banks will face increased scrutiny from bank examiners and their own management teams to reduce risk taking. Banks could also see earnings squeezed if they feel pressure to raise deposit rates, which could further crimp lending.

That would mean fewer loans to consumers to buy cars, boats, homes and other big-ticket items, and less credit for businesses to hire, expand or invest, raising the risk of a steeper economic downturn.

Banks with fewer than $250 billion in assets account for roughly 50% of U.S. commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending, according to Goldman Sachs.

“I think we’re looking at a sizeable credit crunch,” said Daleep Singh, a former executive at the New York Fed who is now chief global economist at PGIM Fixed Income.

Since officials’ previous meeting, the economy had shown surprising strength, leading to concerns that aggressive rate rises over the previous year hadn’t done enough to slow the economy and lower inflation. Central bankers are concerned that prices will keep rising rapidly if consumers and businesses expect them to.

Inflation fell to 4.7% in January from 5.2% in September, as measured by the 12-month change in the personal-consumption expenditures price index excluding food and energy, the Fed’s preferred gauge. Economists expect the government to report next week that the inflation rate was unchanged in February.

Banking stress had led to questions in the past week over whether the Fed would even raise rates at all.

Some analysts fretted that a timeout on rate rises would risk so-called financial dominance, in which monetary policy becomes overly focused on avoiding market stress to the detriment of fighting inflation. A big market rally, in which stock prices rise and borrowing costs fall, could spur more demand and fan price pressures.

“They’d like to avoid that,” said William English, a former senior Fed economist who is a professor at Yale School of Management.

Others said the Fed would have been hard-pressed not to raise interest rates given recent strength in the economy and aggressive measures taken to shore up confidence in the banking system.

“Right now pausing would cause disruption,” said Donald Kohn, a former Fed vice chair. Deciding against raising rates would “signal that they don’t have confidence in their financial stability tools.”

Jan Hatzius, chief economist at Goldman Sachs, disagreed. It would have been better for the Fed to move cautiously given the highly uncertain environment that resulted from the banking stress, he said. “If more issues crop up after Wednesday, that’s also not going to be very confidence inspiring,” he said.

Fed officials have tried to signal their interest-rate moves deliberately over the past year to avoid the kind of market turmoil set off in 1994, when the Fed doubled its short-term benchmark rate from 3% to 6% in a 12-month span.

That rapid tightening hammered stocks and bonds and indirectly contributed to the demise of Kidder Peabody & Co., the bankruptcy of Orange County, Calif., and Mexico’s peso devaluation, which required a bailout from the U.S. and the International Monetary Fund.

After skipping on a rate increase in December 1994, as the peso crisis intensified, the Fed made a final rate increase in early 1995.



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The End of Japan’s Negative Rates Will Be a Slow-Moving Tsunami

Long-term effects of positive Japanese rates could be profound—on everything from mortgage rates to U.S. government finances

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Japan’s stocks have reached levels that haven’t been seen for 34 years . The country is likely to hit another milestone soon: Its central bank could raise interest rates for the first time in 17 years as soon as Tuesday.

Higher, and positive, Japanese rates won’t reshape markets overnight. But the long-term effects could be profound, particularly if U.S. growth heads structurally lower for any reason, further narrowing the yield advantage of many U.S. assets. Japan is the single largest overseas holder of U.S. Treasurys, a major overseas lender, and an export heavyweight whose corporate earnings—and stocks—have been significantly supported by the ultra cheap Japanese yen. More Japanese capital staying at home could eventually impact the price of everything from U.S. mortgages to infrastructure finance in the developing world.

For much of the past two years, Japan has swum against global monetary tides, maintaining its ultra low interest-rate regime. But now, as most other major central banks are about to cut rates, the Bank of Japan is poised to break the trend again. Domestic media reported over the weekend that Japan’s central bank will end its negative interest rates, which have been in place since 2016, during its policy board meeting on Monday and Tuesday.

The decision would come after mounting evidence that the job market is on an increasingly strong footing , after years of stagnant wage growth. Unions secured an average salary increase of 5.28% , according to the first-round results of Japan’s annual spring wage negotiations, the Japanese Trade Union Confederation said last week. For the entire decade ending in 2022, the final annual increase never exceeded 2.4%.

Much likely won’t change in the short term. The Bank of Japan will probably pace its rate increases slowly: The past couple of years have, if anything, reaffirmed its reputation for moving slowly and deliberately. Moreover, while inflation is still high by Japanese standards—2.2% in January—it has already cooled from the peaks of last year.

Japanese bond yields have picked up, but they are still substantially lower than in the U.S. The rate differential between 10-year government bonds in the U.S. and Japan stands at 3.5 percentage points. That is significantly lower than the 4.2-percentage-point gap of a few months ago, but still way higher than the 1.5 percentage points of three years ago.

Even so, a narrowing rate gap—especially if the Fed cuts rates later this year, as seems likely—will support the Japanese yen . That could damp enthusiasm for rip-roaring Japanese stocks . They would become more expensive in dollar terms for foreign investors, who have been significant drivers of the rally. A stronger yen would also hit profits at some Japanese companies , especially big exporters.

Likewise, gradual interest-rate increases in Japan probably won’t change investment flows much in the short term. But it could be a different story down the road if the shift back to positive rates proves sustainable.

Japanese individuals and companies have been big investors abroad in search of higher yield for decades. The country’s foreign-portfolio investments stood at the equivalent of $4.2 trillion at the end of last year. A big chunk of that comes from Japanese pension funds and insurers, who would suddenly have more attractive options at home. Japanese investors, for example, hold around $1.1 trillion of Treasury bonds, making them the largest foreign owner.

Japanese investors have been scouring the globe for better returns for as long as most investors can remember. If that starts to change, the effects will be felt nearly everywhere—sooner or later.

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