Interest rates are expected to rise by a quarter point, but the Fed must prove it can stop a banking crisis

The Federal Reserve is anticipated to increase interest rates by a quarter percent on Wednesday. However, it also has a difficult time convincing markets that it can avert a major banking crisis.

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On Wednesday afternoon, most economists anticipate the Fed to raise its fed funds target rate range to 4.75% to 5%, however, others believe the central bank may decide to hold off on this move owing to worries about the banking sector. As of Tuesday morning, futures markets had an estimated 80% chance of a rate increase.

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While attempting to calm the markets and halt additional bank runs, the central bank is considering using its interest rate powers. Rising interest rates, it is feared, might further strain banking institutions and restrict lending, harming small businesses and other borrowers.

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According to the broader macro statistics, additional tightening is necessary, according to Bank of America's chief U.S. economist, Michael Gapen. The Fed will need to defend its double-barreled policy, he claimed. In order to allay concerns about deposit flights at medium-sized banks, you must demonstrate your ability to walk and chew gum at the same time.

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Federal regulators intervened to guarantee bank deposits at the defunct Silicon Valley Bank and Signature Bank, and they gave banks better loans for up to a year. After UBS's decision to purchase troubled Credit Suisse, the Fed joined forces with other central banks from across the world on Sunday. This was to increase liquidity through the standing dollar exchange mechanism.

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Investors will be turning to Fed Chairman Jerome Powell for assurance that the central bank can control financial issues.

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In terms of the regional bank concept, Gapen remarked, "We want to discover if it's really just a few eccentric institutions and not a more endemic problem." The market wants to know that you believe you comprehend the issue and that you are prepared and able to take action. ... They are really adept at identifying the source of the pressure and knowing how to react, in my opinion."

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A month of turmoil

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In the past month, the markets have fluctuated wildly, first due to hawkish Fed comments and later due to concerns about the banking system spreading contagion.

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The two-day conference of Fed officials gets underway on Tuesday. The event gets underway only two weeks after Powell informed a congressional committee that the Fed might need to raise rates even further than anticipated. This is in order to combat inflation.

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These remarks caused interest rates to rise. A few days later, the unexpected failure of Silicon Valley Bank shocked the markets and sharply lowered bond yields. Bond yields move the other way from price. What was anticipated to be a half-point raise two weeks ago is now up for debate at a quarter point or perhaps zero increase in the Fed rate.

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Monday and Tuesday saw a calmer atmosphere on the markets, with stocks increasing and Treasury yields moving up. The move comes after some concerns about the world banking system were allayed by UBS's weekend deal to purchase Credit Suisse for $3.25 billion.

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Nonetheless, concerns linger regarding First Republic, a regional bank in the United States, which last week accepted deposits totaling $30 billion from a group of banks. According to David Faber of CNBC, JPMorgan is attempting to assist the bank in finding alternatives, such as a capital raising or sale.

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When Treasury Secretary Janet Yellen warned the government might backup deposits at other institutions if required, First Republic stock climbed Tuesday along with other regional banks.

Messaging is the key

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Gapen anticipates Powell ensuring investors that the Fed can use further tools to maintain financial stability while also describing how the Fed is battling inflation

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"Everything moving forward will be handled one meeting at a time. Data will be required, according to Gapen. We must wait and observe how the economy changes. ... We'll have to wait and see how the economy performs and how the financial markets act."

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At 2:00 p.m., the Fed will announce its decision on interest rates as well as its updated economic forecasts. Wednesday, ET. Powell's speech is set for 2:30 PM. ET.

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“The issue is they can change their forecast up to Tuesday, but how does anyone know?” - Diane Swonk, Chief Economist at KPMG

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Gapen believes the Fed may have heightened expectations for the terminal rate—the point at which rate increases will end—than it did in December based on its forecasts. He predicted that it might increase from an earlier estimate of 5.1% to around a level of 5.4% in 2023.

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Jimmy Chang, chief investment officer at Rockefeller Global Family Office, predicted that the Federal Reserve would increase interest rates by a quarter point to boost confidence. This is before concluding that further rate increases were no longer necessary.

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“The initial knee-jerk reaction from the stock market is a rally,” he said, “so I wouldn't be surprised if we had one. Historically whenever the Fed stops raising, going into that pause mode, the stock market's immediate reaction is a rally."

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He claimed that although the Fed won't likely announce a stop, its language may be seen to mean just that.

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Chang stated, "Today, at the very least, they want to convey this impression of stability or confidence. They won't do anything, in my mind at least, that might disturb the market. ... I believe the market will believe this is the last raise based on their [projections].” 

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Fed guidance could be up in the air

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Because of the economy's unpredictability and the fact that a decline in bank lending would be equal to a tightening of Fed policy, Diane Swonk, chief economist at KPMG, said that the Fed is likely to postpone raising interest rates.

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She does not anticipate any direction on upcoming hikes at this time, and Powell may emphasize that the Fed is keeping an eye on developments and the economy's data.

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“I doubt he'll be able to commit. I think he ought to state that all options are on the table. Whatever is required will be done to advance price stability and financial stability,” Swonk added. "Indeed, there is sticky inflation. The economy is showing symptoms of deterioration.”

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Because of the uncertainty that has been generated by the bank troubles, she also anticipates that the Fed's quarterly economic forecasts will be challenging to deliver. The Fed may temporarily halt predictions, as it did during the epidemic in March 2020, according to Swonk.

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"I believe it's crucial to consider the fact that this is changing predictions in unexpected ways. You shouldn't make unwarranted promises,” she advised. Swonk anticipates that the Fed will not release its infamous "dot plot," a chart that displays official Fed estimates of the future direction of interest rates in an anonymous manner.

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“The problem is that, although they can alter their forecast up until Tuesday, how can anyone know? You want the Fed to appear cohesive. You don't want disagreement,” Swonk said. 

“Literally, these dot plots might change daily. We had a Fed chairman prepare to increase rates by 50 basis points two weeks ago.”

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The impact of tight financial conditions

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Depending on the state of the economy, the Fed may decide to decrease interest rates later this year. This is because of tighter financial conditions alone, according to Swonk. The futures market currently predicts a whole percentage point, or four quarter points, in rate cuts this year alone, which is significantly more aggressive than experts are currently predicting.

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The market might actually be alright with them hiking and declaring a pause. According to Peter Boockvar, chief investment director at Bleakley Financial Group, "If they do nothing, maybe the market gets scared that after two weeks of uncertainty, the Fed's pulling off its inflation fight. We still have a difficult path ahead of us, regardless."

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Instead, the Fed might take unexpected action by halting the outflow of securities from its balance sheet. The Fed no longer replaces Treasurys and mortgages as they get older, as it did before and after the epidemic to help the financial markets stay liquid. Gapen said it would be unexpected for the balance sheet runoff. He claimed that between January and February, $160 billion slid off the balance sheet.

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Recently, the balance sheet expanded once more.

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The good news, he continued, "is that much of the money was transferred to institutions that are already known. The balance sheet rose up by roughly $300 billion."