Panic in banks is causing anxiety among investors. Will the Fed make things worse?

The flash crash of three banks and the financial industry saving the fourth focused on the Federal Reserve’s decision next week on whether to continue raising interest rates.

Just two weeks after Fed Chairman Jerome Powell suggested that rates could rise even higher than previously forecast in an attempt to stem inflation, many analysts expect a hike of no more than 0.25 percentage point, while some experts urge politicians to take a stand for fear of further destruction of the banking system.

The challenge highlights the multiple and conflicting challenges facing the Fed. With key sectors of the economy developing and inflation still high more than double With the Fed’s target rate at 2%, the central bank is well aware that any sign that it is relenting in its fight against inflation could trigger another wave of price hikes.

At the same time, the federal funds rate hike now could add to the problems at other lenders, which have caused panicked depositors to pull their money out of the Silicon Valley bank.

“There’s been a financial crash and we’re going from no landing to a hard landing,” Torsten Slok, chief economist at private equity firm Apollo Global Management, said in a note this week that predicted the Fed would keep rates steady when officials meet on 21 – March 22.

Cathy Bostiancic, Nationwide’s chief economist, also believes the current strain on the nation’s banking system could make Fed officials think twice about raising rates next week.

“A lot of people, even myself, were surprised that the Fed raised rates [4.5 percentage] points for 11 months and nothing broke. It finally vindicates the view that the Fed can’t raise rates so fast that nothing happens,” she told CBS MoneyWatch.

Treasury problem

While SVB failed in part due to financial mistakes, analysts say rising interest rates played a crucial role in its collapse. Flooded with customer deposits during the pandemic, the bank grew rapidly and invested a significant portion of those funds in long-term Treasuries and mortgage-backed securities.

But when the Fed raised rates, SVB’s investment lost value. This left the bank short of deposits, just as customers, frightened by possible losses at SVB, were rushing to withdraw their money. The concern now is that this pattern could be repeated at other banks ill-prepared for further rate hikes.

“We also observe the fear of balance sheet problems in regional banks,” Bastiancic said. “Certainly, there is evidence that the banks, having received this huge influx of deposits, a significant amount went into treasury securities. There are other banks that are facing this problem.”

Already, some clients of small and regional banks are transferring their funds to the largest institutions, Financial Times correspondent Steven Gundel told CBS News.

Did the Fed make this mess?

What primarily led to the rapid growth of SVB deposits? In the early years of the pandemic, more Americans were cash-rich, while the tech industry saw explosive growth. According to economists, both factors were caused by the government’s response to the COVID-19 crisis: spending money on consumers and businesses, and keeping interest rates at zero for many months after the initial crisis in 2020 passed.

The danger now is that the Fed, having stepped on the gas too hard in recent years to keep the economy moving forward, is now hitting the brakes and risking a meltdown.

“Like a poor fool, the US Federal Reserve overreacted to the inflationary cold spell during the COVID crisis, easing financial conditions too far and for too long,” Gavekal Research’s Will Denyer wrote in a note this week. “The risk now is that the Fed has turned the knob too far in the other direction … tightening conditions so much that it has initiated a process of disinflation that will spiral downward, likely leading to a recession.”

Tightening of financial conditions

The Fed’s main tool for controlling inflation is using the benchmark overnight lending rate to slow the economy. But many economists say inflation is now cooling enough on its own without the need for more help from the Fed, especially given the lag between monetary policy and economic growth. The current turmoil in banking and financial markets will also make lenders more cautious, further curbing inflationary pressures.

“Going forward, banks, especially small and medium-sized banks, are likely to significantly tighten their lending standards,” Nationwide’s Bostiancic predicted. “Fed officials should consider that more cautious bank lending will be an additional drag on economic activity, and that could be significant.”

Conversely, the Fed may well decide that it has done enough to shore up the banking system after the collapse of SVB and New York’s Signature Bank, and will continue to raise interest rates. After these failures, the Fed created a new lending program, effectively insuring the Treasuries of other banks against losses for up to a year. The central bank could stay on course to raise rates as a sign of confidence in its policy measures and its continued commitment to reducing inflation.

“Which decision shows that they are still cautious about inflation and believe in the stability of the banking system? What message conveys stability and confidence?’ asked Ed Mills, a Washington-based analyst at Raymond James. “I think the Fed is fine with having another week to digest this.”

“The banking industry runs on confidence as much as it does capital, and the banking industry is very well capitalized at the moment,” Mills added. “But there is a real question of trust.”