US Raises Interest Rates Despite Banking Turmoil: Implications and Analysis

The US central bank has raised interest rates by 0.25 percentage points despite concerns that this move could lead to further financial instability following a series of recent bank failures. The Federal Reserve has described the banking system as “sound and resilient,” but also warned that the fallout from these failures could harm economic growth in the coming months. The aim of the increase in interest rates has been to stabilize prices, but this sharp increase since last year has led to strains in the banking system.

Silicon Valley Bank and Signature Bank have collapsed in part due to problems caused by higher interest rates. There are concerns that rising interest rates may make bonds held by banks less valuable. Banks typically hold large portfolios of bonds, and as a result, they are sitting on significant potential losses. Authorities around the world do not think the failures threaten widespread financial stability and are focusing on bringing inflation under control. Federal Reserve Chairman Jerome Powell said the Fed remained focused on its inflation fight, and although he described Silicon Valley Bank as an “outlier” in an otherwise strong financial system, he acknowledged that the recent turmoil was likely to drag on growth, with the full impact still uncertain.

Economic impact

Forecasts released by the central bank indicate that officials expect the economy to grow by only 0.4% this year and 1.2% in 2024, indicating a sharp slowdown compared to previous years, and less than officials projected in December.

The Federal Reserve’s statement has also downplayed its earlier statements that “ongoing” interest rate increases would be necessary in the coming months. Instead, the Fed said that “some additional policy firming may be appropriate.”

The actions “clearly signal that the Fed is nervous,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics.

Wednesday’s rate hike marks the ninth in a row by the Fed, increasing its key interest rate to 4.75%-5%, up from near zero a year ago, the highest level since 2007.

Higher interest rates mean that the cost to buy a home, borrow to expand a business, or take on other debt goes up. By making such activity more expensive, the Fed expects demand to fall, cooling prices.

This has started to occur in the US housing market, where purchases have slowed significantly over the past year, and the median sales price in February was lower than it was a year ago, the first such decline in more than a decade.

But overall, the economy has held up better than expected, and prices continue to climb faster than the 2% rate considered healthy. Inflation, the rate at which prices climb, rose 6% in the 12 months to February. The cost of some items, including food and airfare, is surging even faster.

Before the bank failures, Federal Reserve Chairman Jerome Powell had warned that officials might need to raise interest rates higher than expected to bring the situation under control.

The bank projections indicate that policymakers expect inflation to fall this year, but less than expected a few months ago. Nonetheless, they forecast interest rates of approximately 5.1% at the end of 2023, unchanged since December, indicating that the Fed is poised to stop raising rates soon.

Powell described the effect of the recent turmoil as the “equivalent of a rate hike.” He said the Fed might be able to raise its key rate less aggressively if the financial system’s turmoil prompts banks to limit lending, and the economy slows more quickly. But he reiterated that the Fed would not shy away from its inflation fight.