That’s the shortlist of what Fed officials will confront Tuesday at the start of their two-day policy meeting. The central bank’s deliberations typically revolve around the next interest rate hike, and analysts expect a quarter-point hike could be announced Wednesday. But the recent brush with a bank crisis has focused new attention on a key pillar of the Fed’s responsibilities — financial regulation — which garnered far less attention and urgency amid an all-out inflation fight.
Worse for the Fed, its moves to raise rates fast helped fuel the banking turmoil of the past two weeks. Now officials must reassess the extent to which rising rates are destabilizing parts of the economy rather than simply slowing it down. And leaders including Fed Chair Jerome H. Powell and top banking cop Michael Barr must answer why the central bank’s existing policies failed to prevent the dominoes from falling.
“The policy trilemma that the Fed has to solve is almost impossible,” said Joe Brusuelas, chief economist at RSM. “Yet Powell is going to attempt to thread the needle and explain why he has lifted rates, but is keenly focused on the size of the financial shock.”
On Tuesday, stocks moved higher as banking tensions eased. In premarket trading, the Dow Jones industrial average climbed 0.8 percent, while the S&P 500 and tech-heavy Nasdaq added 0.7 and 0.5 percent, respectively. Major European indexes swelled, with the pan-European Stoxx 600 and Britain’s FTSE 100 both popping 1.4 percent.
Policymakers sought to reassure the financial system and the markets that the moves to prevent a wider crisis are working. Treasury Secretary Janet L. Yellen will give remarks before the American Bankers Association Tuesday morning, and Fed Chair Jerome H. Powell will speak at a news conference Wednesday, at the conclusion of the Fed’s two-day policy meeting.
“The situation is stabilizing. And the U.S. banking system remains sound,” Yellen will say Tuesday, according to her prepared remarks. “The Fed facility and discount window lending are working as intended to provide liquidity to the banking system.”
The implosion of Silicon Valley Bank is only the latest shock to upend the Fed’s attempts to slow the economy and bring prices down to normal levels. Last year, Russia’s invasion of Ukraine was a major reason inflation soared to 40-year highs. Before that, covid surges made it even more difficult to figure out how the economy was faring.
But even in a world seized by a war or a pandemic, there was little public concern that the banking system would be the next shoe to drop.
As the Fed signaled that rates would continue climbing and stay high, though, the value of bonds issued at lower interest rates went down. Silicon Valley Bank held an unusually high percentage of its assets in Treasury bonds and other long-term instruments that suddenly weren’t worth what they were before the Fed’s campaign began. Those are normally considered safe assets, but when customers began panicking and scrambled to withdraw their funds nearly two weeks ago, the problems on SVB’s balance sheet became clear.
The alarm that followed roiled financial markets to such an extreme degree that the Fed could no longer justify scaling rate hikes back up to respond to a hot labor market and still-high inflation, experts say. Markets expect a quarter-point increase this week, which would bring the federal funds rate to between 4.75 and 5 percent.
But some experts argue that the safer approach would be to pause rate hikes until calm is restored, or until it is clear that the bank fiasco is truly over. Problems in the financial markets have the additional effect of tightening financial conditions even further. They can mimic aggressive rate increases that are as low as half a percentage point, or as high as 1.5 percentage points, according to economists’ estimates. That suggests the Fed could afford to scale down its rate hikes to avoid overkill.
“I think they want to pause, and not necessarily say they are changing the trajectory long term, but that there’s enough chaos in the markets … and that they are in a holding pattern, temporarily, with respect to monetary policy,” said Kathryn Judge, an expert on financial regulators at Columbia Law School. “They remain committed to price stability, but do not want that commitment to be pursued so blindly that they ignore the possibility of serious dysfunction.”
Whether the Fed manages to deliver that message hinges on Powell’s news conference Wednesday. Over the course of an hour, he’ll have to defend the Fed’s interest rate announcement and explain any changes to the central bank’s latest crop of economic projections, which show what policymakers think will happen to the unemployment rate, inflation, economic growth and the Fed’s policy rate.
But unlike most recent news conferences, this one will likely also focus heavily on bank supervision and the Fed’s role in the financial system. Powell will probably be asked about the decisions that culminated in the Fed opening a lending program to help keep money flowing through the banking system after SVB failed. On Sunday, the Fed also announced it was coordinating with other major central banks to ease strains in dollar funding markets, a major move that was previously employed in 2020 — when the pandemic started — and 2008, during the financial crisis that led to the Great Recession.
Ultimately, Powell will have to answer to the growing blame game, as lawmakers, financial regulators and the American public point fingers. Republicans and Democrats alike are asking whether neglect at the Fed board or the San Francisco Fed, which was in charge of overseeing SVB, led to the bank’s demise. Sen. Elizabeth Warren (D-Mass.) is calling for an end to rate hikes altogether.
The Fed has launched an investigation into what went wrong, but some cast doubt on the legitimacy of an internal probe. The New York Times and Wall Street Journal have reported that the Fed’s warnings about SVB were not new, but still fell short.
“I do think there’s going to be some sort of independent investigation to supplement what’s going on [under] Barr,” said Peter Conti-Brown, an expert on the Fed and financial regulation at the University of Pennsylvania. “I think it will, and I think it should.”
It also remains to be seen whether upheaval in Europe over Credit Suisse will cause further consequences in the United States. Late Monday, Wall Street still appeared uneasy about First Republic Bank, a California-based institution where big finance firms agreed last week to deposit $30 billion to quell concerns about its liquidity.
Attention is also shifting to a 2018 deregulation law that meant smaller lenders did not face the strictest rules that apply to much larger banks, such as Goldman Sachs or JP Morgan. Congress passed the law with bipartisan support, and when the Fed implemented it in 2019, Powell supported the move. He frequently sided with the Fed’s top banking cop at the time, Randal Quarles, who led the charge during the Trump administration to ease restrictions. (Powell has since said that he defers to the vice chair for supervision on regulatory matters, no matter who is in place.)
But even once Quarles resigned from the job in late 2021, financial regulation received far less attention. The Biden administration showed no urgency nominating a replacement or defining a financial regulatory agenda. And meanwhile, the Fed repeatedly had to reframe its plans for interest rates and inflation. The top oversight job ultimately sat empty until July 2022, when Barr was confirmed.
