The Federal Reserve has decided to forge ahead in its fight against inflation, despite several bank closures that have caused turbulence in the financial markets. On Wednesday, the Federal Open Market Committee (FOMC) announced the decision to raise the federal funds rate by 25 basis points to 4.75%-5%.
“The U.S. banking system is sound and resilient. 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. The Committee remains highly attentive to inflation risks,” the FOMC said in a statement.
Expectations that the Fed could increase rates by 25 basis points – or pause its monetary tightening – have grown over the last few weeks following the Silvergate Bank, Silicon Valley Bank and Signature Bank failures, the rescue of First Republic Bank and the acquisition of Credit Suisse by its competitor UBS. A number of financial institutions in the U.S. are suffering from a lack of liquidity amid deposit runs.
The latest Fed decision follows four subsequent 75 basis point increases in rates, which occurred in June, July, September and November, a 50 basis point increase in December and 25 basis points in February. Monetary policy observers had previously forecasted a 50 basis point increase for the March meeting, as inflation is three times higher than the target.
However, besides the bank crisis, the Fed found support for its decision on the cooling inflation data. In February, the Consumer Price Index (CPI) rose by 6% before seasonal adjustment compared to one year ago, lower than the 6.4% increase recorded in the 12 months ending in January. The CPI increased 0.4% on a monthly basis in February after rising 0.5% in January.
Analysts said that an increase in rates would be counterproductive to manage the current turbulence for banks. The assets banks have in their portfolios and need to sell to pay for their customers’ withdrawals usually have a price reduction when interest rates rise. Ultimately, the Fed can escalate the crisis by increasing the federal funds rate, these analysts said.
In addition, the stress on smaller banks may result in tightening lending standards, requiring fewer rate hikes from the Fed to cool down the economy and combat high inflation. Analysts at Goldman Sachs estimate that the current turbulence could bring an incremental U.S. economy growth drag of 25 to 50 basis points in 2023.
“Our rule of thumb implies that this incremental tightening in lending standards would have the same impact on growth that roughly 25-50 basis points of rate hikes would have via their impact on market-based financial conditions,” Goldman Sachs analysts wrote.
But “the Fed believes work remains to be done,” according to Michele Raneri, vice president and head of U.S. research and consulting at TransUnion. “From a consumer credit perspective, the impact of further rate hikes will likely continue to be felt by borrowers, particularly in industries such as mortgage and credit cards,” Raneri said in a statement.
Impacts on the housing market
In the housing market, the bank collapses sent mortgage rates downward. Investors looking for a safe harbor bought treasury bonds, reducing their yields. Mortgage rates are historically correlated to the 10-year Treasury, which has dropped by more than 40 basis points since the beginning of March.
As the banks’ crisis unfolds, mortgage rates have remained volatile. At the HousingWire Mortgage Rates Center, the Optimal Blue data shows rates at 6.53% on Tuesday, up from 6.42% on Friday. Meanwhile, Mortgage News Daily showed the 30-year fixed conventional mortgage rate at 6.75% on Wednesday afternoon, down from 7.10% at the beginning of March but up eight basis points from Monday.
Looking forward, analysts at Jefferies said uncertainty remains on the horizon. “With increasing volatility, we have seen short-term rates come down, and while mortgage rates have come down, it has not been to the same extent as shorter-duration assets,” the analysts wrote in a report.
“At the same time, we acknowledge incremental volatility as a further headwind to the potential recovery for purchase, as both buyers and sellers remain on the sidelines,” the analysts added.