The US Federal Reserve and the Banking System.

Federal Reserve Interest Rate Decision & Impacts

The US Federal Reserve has recently raised its policy rates to a range of 5% to 5.25%, marking the fifth hike in 14 months. This decision comes amid concerns over inflation, which is currently at its worst in 40 years. The Federal Open Market Committee (FOMC) unanimously agreed on the rate hike, pushing the upper end of the federal funds rate target to 5.25%.

The Federal Reserve's Actions

The FOMC's decision to raise policy rates by 25 basis points was influenced by concerns over inflation and the need to maintain a balance between economic growth and inflation management. In the post-meeting press conference, Fed Chair Jerome Powell refused to commit to a pause for the June meeting, stating that it would depend on incoming data. He also dismissed the possibility of a rate cut, citing concerns about inflation. Powell emphasized that the Fed's goal is to reach and maintain a policy stance that is restrictive enough to bring inflation down to 2% over time. He noted that the Fed is closely monitoring inflation data and will make decisions on policy firming on a meeting-by-meeting basis.

Rapid Interest Rate Hikes

The rapid increase in interest rates by the Federal Reserve has caused borrowing costs for investors and businesses to skyrocket, with the prime rate reaching 8%, nearly three times the level it was a year ago. This has made it difficult for small businesses to secure loans for working capital, equipment, and property purchases, forcing them to reconsider inventory purchases, investments, and hiring. Startups and early-stage businesses are particularly affected, with 76% of them having only enough cash to operate for 60 days.

Inflation Concerns

The current inflation landscape is the worse since the early 1980s, with excessive monetary and fiscal policies being blamed for the rise. Supply-chain snarls, including energy-market and food-system disruptions linked to Russia’s war on Ukraine, have also contributed to the inflationary pressures. The Fed kept its Zero Interest Rate Policy (ZIRP) close to zero for too long and started to unwind its balance sheet too late. Meanwhile, wages have not kept pace with inflation, and most households have been experiencing a decline in real income for the last two years.

Relaxed Regulations From 2019

In 2019, three of the largest US regional banks successfully lobbied regulators to ease their capital requirements by excluding paper losses on their investment portfolios. They claimed that doing so would allow them to increase lending and better manage interest rate risk. However, a recent analysis shows that lending at these banks, PNC, US Bank, and Capital One, as well as lenders they have since acquired, rose more slowly than at rivals.

Loans made by the trio of banks collectively rose just 6% in the three years from 2019 to 2022, while JPMorgan Chase, which was not exempted from the rules, increased lending by 18% over the same period. Unrealized losses over the same time period soared nearly 1,400% to $40bn at the three banks after the Federal Reserve rapidly increased interest rates. The regulatory relief enabled the regional banks to artificially bolster an important gauge of financial health, pointing to the fact that Silicon Valley Bank failed in part because of such losses.

The Fed is considering whether to reverse the 2019 change that allowed large regional lenders to fully exclude any market losses in their bond portfolios from their capital calculations. Lenders are pushing back, saying that reversing the rule could intensify the current bout of banking turmoil.

The Health of the US Banking System

The recent bank failures have raised concerns about the banking system and its impact on the economy. The Federal Reserve's aggressive rate hikes have been cited as a contributing factor to these failures. The FDIC has covered the losses while JP Morgan has bailed out depositors, highlighting the issue where corporations privatize gains and socialize losses. This situation also raises concerns about the violation of US regulations that prevent monopolies from forming in the banking sector. Economists have warned that if people lose confidence in the banking system, it could lead to a downward spiral. They also noted that the current policy tools that have been relied on for economic growth are not functioning, and there is little room for maneuvering if push comes to shove.

For more analysis on these topics, check out these articles:

1. The Death of First Republic?

2. Parsing the Fed's path to a pause

3. Asset Management: Meeting Charlie Munger

4. The biggest challenge facing US small businesses? Rising interest rates

5. Regional US banks claimed easier capital rules would turbocharge loans

6. What it it's not just one or two, but all of them? The next step will be crucial.

7. US banks under fresh pressure as Nelson Peltz calls for Washington to stem crisis

8. Powell Swats Down Rate Cut in 2023, Purposefully Leaves in Doubt a Pause for June Meeting

9. High US inflation and war are hardly new so why were leaders caught by surprise? | Michael Boskin

10. Fed Hikes by 25 Basis Points, to 5.25% Top of Range. Says, Extent to which Additional Policy Firming May be Appropriate, instead of Pause. QT Continues

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