The US Fed dilemma, hike or not to hike interest rates?

A spate of collapses in US banks have unsettled the applecart for Fed. Its war on taming inflation may hit a wall as dangers on its financial system looms

The US Federal Reserve will be in a bind when its Federal Open Market Committee (FOMC) meets this month to announce its March monetary policy decisions. The two-day meeting of the committee will be followed by a press conference by Chair Jerome Powell. Central Banks across the world are keenly watching how this event unfolds as its decision on Wednesday will likely determine what path major developed and emerging economies take.

But unlike its other monetary policies over the past one year, it will be a different ball game altogether this time around.

Just a week before this big event a series of banking collapses has unsettled the applecart. It began with Silicon Valley Bank (SVB) only to be followed by Signature Bank and First Republic Bank. SVB’s former parent SVB Financial has already filed for Chapter 11 bankruptcy protection and has sought court supervised reorganisation. To bring some more perspective, SVB was US’ 16th largest bank until this happened.

On the other hand, America’s 11 largest banks have extended their support to rescue the San Francisco-based First Republic with a USD 30 billion package.

Not just this, Switzerland-based Credit Suisse bank which also has significant exposure in the US has met with a similar ordeal and local regulators and UBS are now ironing out modalities for a takeover by the latter. UBS is the largest Swiss bank.   

The situation is so precarious that US President Joe Biden had to come forward to assuage depositors. Biden has also called for strict action against officials who are responsible for the mismanagement of these banks. The White House has also requested Congress to pass a legislation and bring a set of large banks under the Dodd-Frank Act.

The failing of these banks has been for a variety of reasons which include growing interest rate scenario, failure of crypto and gross mismanagement of these financial institutions.

Choosing between devil and deep sea

Choosing between raising interest rate to control inflation or not doing it to let economy grow is a hard choice that can be likened to selecting between devil and deep sea. Fed’s aggressive rate hikes from zero to the range between 4.5-4.75 per cent is unprecedented and have only increased hardships for its people. But with an inflation of near 10 per cent (when the rate hiking exercise began last year), it had very little handle to control. The world’s largest economy had not seen this colossal inflation situation in the last four decades.

In his testimony to the US Senate Banking Committee, Powell reiterated Fed’s commitment to ensure price stability by bringing down inflation to 2 per cent level. It would do that even if it meant increasing rates more aggressively, Powell had told the committee.

The question before all of us is that has Fed’s war on inflation hit the wall on the back of banking collapses or it will be brave enough to keep increasing interest rates. We will know that in due course. 

To be fair to Powell, his job as a Central Bank Chief has been very tough which has now become even more difficult.

The jury is out on whether there will be a rate hike of at least 25bps or the Fed will put a pause until the dust from bank failures settle down.

But SVB’s failure is a big eye opener for all the Central Banks to take a pause and reflect if the strategy to hike rates and control inflation is the way forward and if this is the only way to control inflation for all economies irrespective of how different their macros and micros are from one another.

What Triggered SVB Collapse

SVB’s collapse was quite dramatic and happened in a span of two days. Its failure was on multiple counts – one was its over concentration in start-ups and geography (Silicon Valley) and the other was the high interest rate regime.

Customers sensed that the bank would at some point come into trouble amid an unabated interest rate hike. They began pulling out their deposits in the bank leading to an instant debacle.   

But the trigger was interest rates that went up to unprecedented levels. SVB invested billions of dollars into US government bonds at the time when interest rates were nearly zero. When rates began increasing the bond prices dropped significantly eroding the value of the government bonds. Prices of bonds are inversely related to the movement of the interest rates. 

According to a Reuters report the portfolio was yielding an average 1.79 per cent return in the previous week much lower from the 10-year treasury yield of around 3.9 per cent.

Problem at Hand

Global growth outlook is far from inspiring and the questions have now started emerging as to how long the rate hiking activity would continue. The impact of rate has not had a material impact on taming inflation according to Fed’s own admission. Moreover, the impact of rate hike on inflation comes with a lag but its impact on people is at a much faster rate.

While it is sucking the liquidity from the system, the cost of living is only going up for many Americans. Increasing interest rates may cut potential discretionary consumption but what happens to the essential spending.

The tenure and payouts of the loans are ever rising.

The slowing economy is having a catastrophic impact on livelihoods as people are losing jobs as companies are cutting cost by what they call “rightsizing”.

It is a contagion that is spreading fast. The looming danger is that there could be defaults on the loans that have already been taken by the people.  

Also, investments in those bonds which were bought when interest rates were low run a danger of further value erosion.

The India Context

The Indian banking system is far more robust and unlikely to experience anything remotely similar. The regulators are quite nimble footed and we saw how RBI acted to save an Indian private bank.

So, the Indian banking regulator is not pressed against the wall. But, higher EMIs and longer tenures are hurting those who already have loans.  

Retail credit off-take from banks could take hit if the interest rates continue to move up. For now, the banks are in a comfortable situation. It will be interesting to see what course RBI takes in its April Monetary Policy but many overwhelmingly want a rate pause if not a rate cut.   

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