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Banks are running scared. Is the Federal Reserve about to make things worse?

Yellen reaffirms strengths of banking system
Treasury Secretary Janet Yellen reaffirms strength of U.S. banking system 04:53

The lightning collapse of three banks and the financial industry rescue of two others are shining a spotlight on the Federal Reserve's closely watched decision this week over whether to continue raising interest rates.

Just two weeks after Fed Chair Jerome Powell suggested the central bank could hike rates even higher than previously projected in an effort to quash inflation, many analysts now expect no more than a 0.25 percentage-point hike when the bank's rate-setting body announces its decision Wednesday.

Other experts are urging policy makers to hold the line for fear of further unsettling the banking system.

"Expectations for the March [Federal Open Market Committee] meeting have changed abruptly over the last 10 days," analysts at Goldman Sachs wrote in a note on Monday, referring to the Fed panel that sets interest rates. "We expect the FOMC to pause at its March meeting this week because of stress in the banking system. While policymakers have responded aggressively to shore up the financial system, markets appear to be less than fully convinced that efforts to support small and midsize banks will prove sufficient."

The quandary highlights the multiple, and conflicting, issues facing the Fed. With key sectors of the economy going strong and inflation still more than double the Fed's target rate of 2%, the central bank is keenly aware that any sign it is relenting in the battle against inflation could give rise to another wave of price increases. 

At the same time, lifting the federal funds rate could now magnify other lenders the same kind of problems that led panicked depositors to yank their money out of Silicon Valley Bank.

"The failures of SVB and Signature, along with ongoing stress in the regional banking sector, has greatly complicated the Fed's monetary policymaking," Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote in a note this week. "[T]he Fed cannot gamble with the integrity of the system."

Kathy Bostjancic, chief economist at Nationwide, also thinks the current stress on the nation's banking system could make Fed officials think twice about hiking rates.

"Many people, even myself, had been surprised that the Fed raised rates by [4.5 percentage] points in 11 months and nothing did break. It's finally vindicating the view that the Fed can't raise rates that fast without something happening," she told CBS MoneyWatch.

The Treasury problem

While SVB failed partly because of financial missteps, analysts say rising interest rates played a critical role in its collapse. Flooded with customer deposits during the pandemic, the bank grew rapidly and put much of these funds into long-term Treasury bonds and mortgage securities. 

But as the Fed jacked up rates, SVB's investments lost value. That left the bank short on deposits just as customers spooked by SVB's potential losses were rushing to withdraw their money. The concern now is that this pattern could repeat itself at other banks ill-prepared for further rate hikes.

"We're also seeing fear of balance-sheet issues at regional banks," Bostjancic said. "There's definitely evidence that banks, as they've received this tremendous inflow of deposits, a significant amount went into Treasury securities. There are other banks that are facing that issue."

Already, some customers at small and regional banks are moving their funds to the largest institutions, Financial Times correspondent Stephen Gandel told CBS News.

Large banks see influx of new depositors following SVB collapse 05:59

Did the Fed make this mess?

What led to SVB's fast growth in deposits in the first place? More Americans were flush with cash in the early years of the pandemic, while the tech industry saw explosive growth. According to economists, both factors were fueled by the government's response to the COVID-19 crisis: hosing consumers and businesses down with cash, while also keeping interest rates at zero for many months after the initial crisis in 2020 had passed.

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

"Like the poor fool, the U.S. Federal Reserve overreacted to the inflation cold spell during the COVID crisis by easing financial conditions too far for too long," Will Denyer of Gavekal Research wrote in a note. "The risk now is that the Fed has cranked the handle too far the other way … tightening conditions so much that it has initiated a disinflationary process that will overshoot to the downside, likely causing a recession." 

Financial conditions tightening

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

"Going forward banks, especially small and medium-sized banks, are likely to tighten their credit standards significantly," Nationwide's Bostjancic predicted. "Fed officials need to consider that more cautious bank lending will be an additional brake on economic activity, and it could be significant."

Former FDIC chair Sheila Bair on turmoil in the banking sector 06:15

By contrast, the Fed could very well decide that it has done enough to shore up the banking system following the collapse of SVB and New York's Signature Bank and continue pushing up interest rates. After those failures, the Fed created a new lending program effectively insuring other banks' Treasury holdings against losses for up to a year.

The upshot: The central bank could choose to stay the course on rate hikes as a sign of confidence in its policy measures and of its unremitting commitment to lower inflation.

"What decision sends a message that they're still cautious about inflation and believe in the stability of the banking system? What message portrays stability and confidence?" asked Ed Mills, Washington analyst at Raymond James. "I think the Fed is fine having another week to digest that."

"The banking industry works on confidence as much as it works on capital, and the banking industry is very well-capitalized at this point," Mills added. "But there is a real question about confidence."

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