What to Watch From the Fed Meeting

The Fed has tried over the past year to telegraph its rate moves to avoid surprises but hasn’t confronted an abrupt and fluid crisis on the eve of a policy meeting. On Tuesday, investors thought a rate rise was likely, with interest-rate futures markets indicating a roughly 5 in 6 chance of a quarter-point increase, according to CME Group.

Officials raised their benchmark federal-funds rate by a quarter-point, to a range between 4.5% and 4.75%, in early February. That was a smaller increase than the half-point they approved in December and 0.75-point at four previous meetings.

Here’s a look at what to watch.

The case for raising rates: Before the collapse of Silicon Valley Bank two weeks ago, officials were set to debate whether to raise rates by a quarter-point or a half-point because of signs the economy was running too hot.

Since officials met Jan. 31-Feb. 1, the economy had shown surprising strength in hiring, spending and inflation, leading to concerns that aggressive rate rises over the previous year hadn’t done enough to slow the economy and corral inflation. Some economists argue that stopping rate increases now risks fueling unacceptable risks that inflation will stay higher for longer.

Fed officials have at times acknowledged the risk of being forced to simultaneously fight two problems—inflation and financial instability. Several have said they would use emergency lending tools to stabilize a shaky financial sector so they could continue to use higher interest rates to cool inflation. And the Fed, working with the Treasury Department, banking regulators and global central bankers, has deployed several of those emergency lending tools over the past two weeks.

“If you do crisis management correctly, you should have a freer hand to do monetary policy,” said

Vincent Reinhart,

chief economist at Dreyfus and Mellon and a former senior Fed economist. “To deflect what you think is the right path of monetary policy because you’re worried about financial stability is to admit you’re not doing regulation, supervision and crisis management correctly. I don’t think the Fed thinks that, in which case they have a free hand” to raise interest rates this week.

Others might also fear a timeout on rate rises would risk so-called financial dominance, in which monetary policy becomes overly focused on avoiding market stress to the detriment of fighting inflation. The Fed raises rates to fight inflation by slowing the economy through tighter financial conditions—such as higher borrowing costs, lower stock prices and a stronger dollar—that curb demand.

“They’re probably a little worried they’ll be seen, in some sense, as knuckling under to financial pressures,” said William English, a former senior Fed economist who is a professor at Yale School of Management. This could lead to a big market rally, in which stock prices rise and borrowing costs fall, fanning price pressures. “They’d like to avoid that,” he said.

The case for holding steady: The banking turmoil creates risks of even more rapid tightening in financial conditions. Lenders will face increased scrutiny from bank supervisors and from their own management teams to reduce risk-taking. In addition, banks could see their earnings squeezed if they feel pressure to raise deposit rates, which could further crimp lending.

Even if all of the risks of further bank runs have been eliminated, banks’ “funding costs are going up, and they’re going to be worrying about the regulatory response to this,” said former Fed governor

Jeremy Stein.

The risk of a “fairly pronounced credit contraction in the banking sector…might lead me towards not hiking at this meeting,” he said.

Economists at Goldman Sachs estimate that the incremental tightening in lending standards that could result from stress at small and midsize banks would be equivalent to a quarter- or half-point increase in the Fed’s benchmark rate.

Jan Hatzius,

Goldman’s chief economist, said he expected the Fed not to raise rates this week because of risk-management considerations: tightening too little would be an easier problem to fix than tightening too much. “Inflation is really an issue monetary policy addresses over a one-to-two year horizon,” said Mr. Hatzius. “Waiting six weeks probably doesn’t make a meaningful difference to the inflation outlook.”

While some former Fed policy makers have argued that not raising rates could raise questions over whether banking problems are more serious than they currently appear, Mr. Hatzius said it was better for the Fed to move cautiously given the highly uncertain environment that resulted from the banking stress. “If more issues crop up after Wednesday and they just hiked by 25 basis points, that’s also not going to be very confidence inspiring,” he said.

Forward guidance: Fed officials can use a suite of tools—their policy statement, rate projections and Mr. Powell’s press conference—to provide more nuance about how their economic forecasts have shifted, how the risks around them have changed and what that means for the likely path of rates.

In December, most officials thought they would raise the fed-funds rate to around 5.1% this year, and their Feb. 1 policy statement suggested “ongoing increases” would be appropriate. How officials describe the most likely path could be as important as their rate decision on Wednesday.

Write to Nick Timiraos at [email protected]

The Fed has tried over the past year to telegraph its rate moves to avoid surprises but hasn’t confronted an abrupt and fluid crisis on the eve of a policy meeting. On Tuesday, investors thought a rate rise was likely, with interest-rate futures markets indicating a roughly 5 in 6 chance of a quarter-point increase, according to CME Group.

Officials raised their benchmark federal-funds rate by a quarter-point, to a range between 4.5% and 4.75%, in early February. That was a smaller increase than the half-point they approved in December and 0.75-point at four previous meetings.

Here’s a look at what to watch.

The case for raising rates: Before the collapse of Silicon Valley Bank two weeks ago, officials were set to debate whether to raise rates by a quarter-point or a half-point because of signs the economy was running too hot.

Since officials met Jan. 31-Feb. 1, the economy had shown surprising strength in hiring, spending and inflation, leading to concerns that aggressive rate rises over the previous year hadn’t done enough to slow the economy and corral inflation. Some economists argue that stopping rate increases now risks fueling unacceptable risks that inflation will stay higher for longer.

Fed officials have at times acknowledged the risk of being forced to simultaneously fight two problems—inflation and financial instability. Several have said they would use emergency lending tools to stabilize a shaky financial sector so they could continue to use higher interest rates to cool inflation. And the Fed, working with the Treasury Department, banking regulators and global central bankers, has deployed several of those emergency lending tools over the past two weeks.

“If you do crisis management correctly, you should have a freer hand to do monetary policy,” said

Vincent Reinhart,

chief economist at Dreyfus and Mellon and a former senior Fed economist. “To deflect what you think is the right path of monetary policy because you’re worried about financial stability is to admit you’re not doing regulation, supervision and crisis management correctly. I don’t think the Fed thinks that, in which case they have a free hand” to raise interest rates this week.

Others might also fear a timeout on rate rises would risk so-called financial dominance, in which monetary policy becomes overly focused on avoiding market stress to the detriment of fighting inflation. The Fed raises rates to fight inflation by slowing the economy through tighter financial conditions—such as higher borrowing costs, lower stock prices and a stronger dollar—that curb demand.

“They’re probably a little worried they’ll be seen, in some sense, as knuckling under to financial pressures,” said William English, a former senior Fed economist who is a professor at Yale School of Management. This could lead to a big market rally, in which stock prices rise and borrowing costs fall, fanning price pressures. “They’d like to avoid that,” he said.

The case for holding steady: The banking turmoil creates risks of even more rapid tightening in financial conditions. Lenders will face increased scrutiny from bank supervisors and from their own management teams to reduce risk-taking. In addition, banks could see their earnings squeezed if they feel pressure to raise deposit rates, which could further crimp lending.

Even if all of the risks of further bank runs have been eliminated, banks’ “funding costs are going up, and they’re going to be worrying about the regulatory response to this,” said former Fed governor

Jeremy Stein.

The risk of a “fairly pronounced credit contraction in the banking sector…might lead me towards not hiking at this meeting,” he said.

Economists at Goldman Sachs estimate that the incremental tightening in lending standards that could result from stress at small and midsize banks would be equivalent to a quarter- or half-point increase in the Fed’s benchmark rate.

Jan Hatzius,

Goldman’s chief economist, said he expected the Fed not to raise rates this week because of risk-management considerations: tightening too little would be an easier problem to fix than tightening too much. “Inflation is really an issue monetary policy addresses over a one-to-two year horizon,” said Mr. Hatzius. “Waiting six weeks probably doesn’t make a meaningful difference to the inflation outlook.”

While some former Fed policy makers have argued that not raising rates could raise questions over whether banking problems are more serious than they currently appear, Mr. Hatzius said it was better for the Fed to move cautiously given the highly uncertain environment that resulted from the banking stress. “If more issues crop up after Wednesday and they just hiked by 25 basis points, that’s also not going to be very confidence inspiring,” he said.

Forward guidance: Fed officials can use a suite of tools—their policy statement, rate projections and Mr. Powell’s press conference—to provide more nuance about how their economic forecasts have shifted, how the risks around them have changed and what that means for the likely path of rates.

In December, most officials thought they would raise the fed-funds rate to around 5.1% this year, and their Feb. 1 policy statement suggested “ongoing increases” would be appropriate. How officials describe the most likely path could be as important as their rate decision on Wednesday.

Write to Nick Timiraos at [email protected]