Powell’s Balancing Act raises some questions


The Federal Reserve’s decision to raise rates by 25 basis points this week split the difference between the larger hike signaled earlier this month and the pause many demanded amid alarm over distressed banks. Under test conditions, the modest increase in the policy rate to a range of 4.75% to 5% is a justifiable compromise. Yet there are cracks in the central bank’s reasoning.

The Fed had to weigh two risks. The first was that maintaining a brisk pace of monetary tightening would deepen the recent turmoil, lead to further inadvertent tightening of financial conditions and cause an abrupt fall in demand. The other was that holding rates, at least for now, would make investors question the Fed’s determination to keep inflation under control.

Things may change, but right now deep-seated inflation is the bigger danger. And to curb inflation, the central bank must convince markets that financial stability and macroeconomic policy are separate tasks requiring different tools. Interest rates should be set in accordance with macroeconomic conditions. Financial stability is best addressed through the sorts of action the Fed has already taken – primarily by providing emergency liquidity to fundamentally sound institutions when needed.

While the tariff compromise is understandable, it calls into question this necessary division of labor.

In his remarks on Wednesday, Chairman Jerome Powell insisted the Fed is not losing anything by moderating its anti-inflation strategy until it has a clearer picture of where it is going. He stressed that the banking turmoil has tightened financial conditions regardless of what happens to key rates, replacing the bigger hike the Fed had previously envisioned. If monetary tightening is still needed later this year, it will resume, as the central bank’s dot charts predict. For now, Powell said, a smaller rate hike and the stress-induced tightening of financial conditions will continue to depress prices.

This logic is plausible but flawed. The Fed cannot credibly promise to raise rates later if it is too easily distracted by doubts about where things are headed. (The so-called “hawkish pause” — embarrassment now, determination later — is a contradiction in terms.) And the supposed tightening due to financial uncertainty is probably exaggerated. Short-term credit spreads and measures of volatility rose sharply in the immediate aftermath of the Silicon Valley Bank collapse, but investors are also betting that the Fed will ease interest rates. The net effect is unclear.

Of course, it was wiser to raise interest rates by 25 basis points than nothing. Aside from the damage to the Fed’s credibility on inflation, an eventual hike might have frightened financial markets more than proceeding, leading investors to believe that policymakers were more concerned about financial fragility than they admit. Clearly, the Fed is grappling with massive uncertainty. What happened to SVB, Credit Suisse and the others raises big, pressing questions about banking regulation and the adequacy of central banks’ emergency liquidity tools. The damage can spread. Renewed unrest is possible. If things get bad enough, demand may indeed collapse. In this worst-case scenario, the Fed needs a whole new set of dot charts.

All that can happen. But high inflation – the biggest problem facing the economy – is not a hypothetical problem: it is here and now. If the Fed is suspected of backing down, it will be much more difficult to resolve.

More from Bloomberg’s opinion:

• The Fed can fight both inflation and bank contagion: Bill Dudley

• Why the Fed rate hikes hit all at once: Paul J. Davies

• As the Fed approaches interest rate spike, be careful what you wish for: Jonathan Levin

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The editors are members of the Editorial Board of Bloomberg Opinion.

More stories like this are available at bloomberg.com/opinion






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