US Federal Reserve raises key interest rate despite banking chaos in the US

The Federal Reserve hiked interest rates on Wednesday – a crucial move that showed the central bank’s determination to fight inflation despite the recent chaos in the US banking sector.

In a much-anticipated decision, the rate-setting Federal Open Market Committee raised its policy rate by 0.25% — to a range of 4.75% to 5% — at the close of the Fed’s closely-watched policy meeting.

Fed Chair Jerome Powell told reporters that FOMC members “considered” leaving rates on hold due to concerns about the banking sector, but ultimately went ahead with a small hike as inflation was high.

The Chair noted that the decision was “supported by a very strong consensus”. The banking crisis is likely to lead to tighter credit conditions, which could have the same cooling effect on the economy as a rate hike, Powell added.

“Such a tightening of financial conditions would work in the same direction as a rate hike,” Powell said. “You can think of it as the equivalent of a rate hike, or maybe more than that.”

The Fed chair said a “small number of banks” had experienced “severe difficulties” but he downplayed further risks to the sector. Overall, according to Powell, the banking system has “strong capital and liquidity” and “deposit flows have stabilized.”

Powell pointed out that the statement from the rate-setting Federal Open Market Committee now says that “additional policy tightening may be appropriate” — a softer stance that indicates the Fed may not need to make more rate hikes.

The Fed’s tough decision has been the subject of heated debate since Silicon Valley Bank and Signature Bank of New York collapsed in the biggest US bank failures since the 2008 financial crisis.

Hedge fund boss Bill Ackman and tech billionaire Elon Musk, among others, have called for the Fed to suspend interest rate hikes – or even cut rates – to avoid further shocks to the economy. Others, like ex-Treasury Secretary Larry Summers, urged the Fed to stay the course and raise rates despite the turmoil.

The hike marked the ninth straight rate hike by the Fed during a rapid tightening of monetary policy last year. The Fed also gained a quarter of a percentage point at its February meeting.

Powell and his colleagues were forced to take into account the crisis in the US banking sector, even though inflation was at 6% – well above the Fed’s 2% target.

The Fed also released updated “dot-plot” forecasts, showing officials expect interest rates to peak at 5.1% this year. Powell noted that committee members are not currently expecting to pass rate cuts in 2023.

Economic growth is expected to be subdued this year in the uncertain environment, with real GDP expanding by just 0.4%. Inflation is expected to fall to 3.3% by the end of the year.

“Investors’ wishes may come true: contagion risks are low enough for the Fed to hike rates and inflationary pressures are low enough for the Fed to almost end its rate hike campaign,” said Jeffrey Roach, LPL Financial’s chief economist.

US stocks initially rose after Powell’s news conference, but then plunged. The Dow Jones Industrial Average rose as much as 200 points before falling 530 points, or 1.6%. The tech-heavy Nasdaq and the broad-based S&P 500 were also down 1.6%.

Another rate hike in March was considered a foregone conclusion earlier this month after a string of hotter-than-expected economic reports.

Just days before the banks collapsed, Powell had warned that the Fed would have to raise rates higher than previously expected to bring prices down.

While rate hikes are the Fed’s primary tool to combat inflation, they also increase the pressure on companies by making interest payments and forms of borrowing more expensive.

A rapid wave of rate hikes last year was a key factor in SVB’s collapse, as the once-popular tech-sector lender was forced to absorb a $1.8 billion loss in a distressed sale of its bond holdings. A recent study found that nearly 200 other banks face similar risks.

Powell said Fed officials are working to assess what went wrong at the SVB and what guardrails should be implemented to prevent similar collapses in the future.

“Management at Silicon Valley Bank failed badly,” Powell said. “They have allowed the bank to grow very quickly, they have exposed the bank to significant liquidity and interest rate risk.”

Bank stocks remained under pressure this week on problems at regional lender First Republic, which has come under attack from concerned depositors.

Elsewhere, UBS Group stepped in with an emergency takeover of Swiss banking giant Credit Suisse after questions surfaced about its survival.

The Fed’s announcement was in line with expectations.

Prior to the FOMC announcement, the market had priced in an 86.4% chance of a quarter-point rate hike and just a 13.6% chance that the Fed would leave rates on hold, according to CME Group’s FedWatch tool.