February core inflation, measured by the Consumer Price Index, climbed from January at a faster month-to-month pace, according to this morning’s report from the Bureau of Labor Statistics. Core inflation, which excludes theoretically more volatile food and energy prices, rose at a 0.50% month-to-month rate in the month after climbing at a 0.40% month-to-month rate in January. That put core inflation on a 5.5% annual pace.
This wasn’t what the Federal Reserve needed to hear as it wrestles with the problem of what to do to contain inflation still running at well above the central bank’s 2% target (and which threatens to edge higher again) at a time when the banking system is showing systemic stress brought on by the Fed’s aggressive interest rate increases.
Here are the Fed’s choices:
1. Raise rates by the 50 basis points that economists agreed were necessary to reduce inflation before the collapse of Silicon Valley Bank. I think this “rate hikes as usual” option is off the table for the March 22 meeting.
2. Raise rates by 25 basis points in a compromise that shows the Fed is responding to the banking system’s problems but remains committed to fighting inflation. I think this is the most likely move by the Fed. Not raising rates at all would have the effect of telling the financial markets that the Fed has given up on inflation and would encourage the belief that the Fed’s next move, perhaps as early as the May meeting, would be to begin to cut interest rates. A 25 basis point increase would, however, raise the odds of a recession. No one knows exactly how big an impact the Silicon Valley Bank collapse will have on lending and the availability of risk capital across the entire economy.
3. Do nothing. But talk about how the Fed remains committed to fighting inflation. I think the financial markets would see this as tantamount to a Fed surrender on inflation. It would, of course, prop up asset prices, but declining stock and bond prices are hardly the biggest worry that the Fed has. This decision would also confirm the doubts that many market observers (including this one) have about the depth of the Fed’s commitment to fighting inflation. And since the real danger is that expectations of inflation get embedded in the thinking of consumers and CEOs, a do-nothing decision would just about guarantee that the current trend toward higher inflation would continue and perhaps speed up.
None of these alternatives on interest rate policy is especially attractive.
And none of them guarantee that the U.S. economy won’t slide into recession in the second half of 2023. The Silicon Valley Bank collapse will make banks and other capital providers less likely to take on risk (although there is no evidence that backing risky investments led to the problems at Silicon Valley Bank. It was the decline in the value of the bank’s safe Treasury bond portfolio that was the proximate cause of the bank’s problems. (The risk was in the bank’s failure to put more money into reserves as the value of that bond portfolio fell.) Nonetheless, the last few days have shown that bank officials see a need to increase capital reserves. That’s not a conclusion that leads to more lending and risk-taking.
One conclusion to draw from the Silicon Valley Bank fiasco–and there are many questions to be asked about the collapse of the bank including How did the regulators for the state of California and at the San Francisco Fed miss the growing problem? and How did the bank’s outside auditors give it a clean bill of health just weeks before the collapse?–is that the Federal Reserve has indeed lost control of the economy. (The belief in the Fed’s powers has always been overstated, I’d note. Interest rate policy is a very blunt hammer that really doesn’t have power over the economic behavior of critical actors in the economy.) We could be looking at one of those periodic episodes when interest rates rise or fall because of consensus market beliefs rather than in reaction to moves by the Fed. And where the question of “Recession/No Recession?” is no longer the Fed’s to answer.
A lot depends on exactly how stressed other banks are right now and what sectors of the economy might feel the full effects of that stress. Unfortunately, we don’t know. Not even the Fed can tell us.
