This week, the Federal Reserve meeting places the Fed in what some call a difficult situation. They can either stick to their initial plan of raising rates by another 25 basis points and signaling more hikes in the future, or they can capitulate, do nothing, and maintain the December dot plot.
Before the Silicon Valley Bank incident, it was a straightforward decision for the Fed to raise rates by 25 basis points and signal a peak terminal rate of approximately 5.50%. However, following the news of Silicon Valley Bank’s failure, investors seem perplexed.
Two Different Directions
Two distinct forces are at play here, complicating matters. However, if the Fed follows the European Central Bank’s example, the Fed is likely to raise rates by 25 basis points and signal that more hikes are on the horizon. After all, the President of the New York Fed stated in November that “using monetary policy to mitigate financial stability vulnerabilities can lead to unfavorable outcomes for the economy.”
There are two aspects to consider: price stability and financial stability. It appears that the Fed has been attempting to control the pace of the economy and the demand side of the equation through interest rates while using its balance sheet and lending facility to manage the liquidity side of the equation.
One could argue that there is still too much liquidity in the system, particularly with nearly $2 trillion per day directed to the Fed through the Reverse Repo facility. Fed board member Chris Waller noted on January 20, “Every day firms are handing us over $2 trillion in liquidity they don’t need. They give us reserves. We give them securities. They don’t need the cash.” The reverse repo facility at the New York Fed has maintained a level above $2 trillion throughout the entire Silicon Valley Bank events.
If we are to believe that monetary policy should not be used to address financial stability issues and there is ample liquidity in the system. Then it becomes difficult for the Fed not to raise rates by 25 basis points this week and signal more rate hikes.
Using Its Tools
The Fed also has various tools to ensure banks have the necessary liquidity, including using the discount window and its new Bank Term Funding Program. Additionally, some banks could merely opt to reallocate the tremendous amounts of cash being placed into the reverse repo facility every day.
If it is true that the Fed firmly believes that without price stability, the economy does not work for anyone and that price stability is the foundation for sustained economic and financial stability, then the Fed could and probably should continue to raise rates. At the same time, they can use other tools along with the excess liquidity in the system to ensure that banks have continued access to their needs.
Inflation Is Still High
The “super” core CPI, which is the core CPI excluding housing, rose by 0.5% in February, up from 0.36% in January. On a year-over-year basis, it ticked down to 6.13% from 6.19% in January but remained well above the pre-pandemic trends.
Meanwhile, core CPI remains notably high at 5.54% year-over-year, down slightly from 5.58% in January. Additionally, it increased by 0.45% month-over-month, up from 0.41% in January. It is difficult to argue that inflation has significantly eased in recent months.
Since hitting its lowest point in December, month-over-month core CPI has risen for three consecutive months and at an accelerating pace. This trend is certainly not in line with the Fed’s desired direction.
Its Own Problems
Additionally, the problem of Silicon Valley Bank may be specific to the bank itself, as the decisions on how they managed their bonds appeared to be conscious. A Wall Street Journal article noted that the bank allowed $14 billion in hedges to expire, exposing the bank to rising rates and contributing to its financial issues. Furthermore, by mid-2022, the bank indicated in a presentation to investors that it shifted its focus to protecting itself from falling rates. This left the bank exposed to further increases in interest rates. It appears the bank bet on rates dropping and lost.
It’s not to say that risks do not exist or that other banks might not be vulnerable. However, one would think that with the new Bank Term Funding Program, banks could convert their held-to-maturity assets into the cash they need to alleviate any existing funding pressure.
If one were to use the market as an overall gauge, it seems that the bad news has been absorbed quite well. According to the Goldman Sachs Financial Conditions Index, financial conditions through March 16 have eased since March 10.
Remarkably, the average Bloomberg Corporate High Yield Option Adjusted Spread has not widened significantly. It is currently lower than it was in July or September of 2022. Furthermore, it is considerably lower than where it stood during the February 2016 collapse in oil prices and well below the levels experienced during the European debt crisis in 2011.
The S&P 500 (SP500) rose 1.4% this past week, while the NASDAQ 100 (NDX) rose 5.8%. Even the Biotech ETF (XBI), which relies heavily on access to capital and is sensitive to lending conditions, rallied by 1.1%. So if there were really worries in markets about the stability of the financial system, one would think risky assets would fall, not rise. Based solely on the equity market reaction, one could argue that the Fed should raise rates by 50 bps on Wednesday because contagion concerns appear not to exist if stocks have a vote and probably demonstrate how much excess liquidity remains.
Yes, bond yields have fallen, but as discussed earlier this week, this is mechanical due to CTA funds aggressively covering short positions.
The Fed Should Hike
If the Fed remains committed to everything it has stated over the past year regarding the importance of price stability, it still has much more work to do. It should follow the same path that the European Central Bank (ECB) recently took, emphasizing the separation between using monetary policy to address inflation and bank lending facilities to address financial stability risks.
This would entail the Fed raising rates by another 25 basis points and signaling that more rate hikes are coming, with no rate cuts expected in 2023.