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Why the Fed will likely raise rates two days after First Republic failed

<i>Olivier Douliery/AFP/Getty Images</i><br/>Federal Reserve Board Chair Jerome Powell speaks during a news conference at the Federal Reserve in Washington
AFP via Getty Images
Olivier Douliery/AFP/Getty Images
Federal Reserve Board Chair Jerome Powell speaks during a news conference at the Federal Reserve in Washington

By Elisabeth Buchwald, CNN

For the second time this year, the Federal Reserve is gearing up to raise interest rates right after a bank failure.

In this instance, the Fed’s decision this Wednesday will come just two days following the collapse of First Republic Bank, the second-biggest bank failure in US history.

Like Silicon Valley Bank and Signature Bank, First Republic’s failure was precipitated by the central bank’s year-long rate hiking campaign. As rates went higher, investments the banks made — particularly in long-term bonds — devalued, leaving lenders sitting on billions of dollars in unrealized losses.

When the Fed raises interest rates, banks need to raise the rates on their savings accounts in order to lure in depositors from their competitors. That can put a disproportionate amount of pressure on mid-sized and regional banks — like the ones who saw depositors pull their money when the banking crisis began in March.

Why, then, is the Fed likely to raise interest rates on Wednesday?

Markets already priced in the rate hike

It’s a lot easier for the Fed to raise interest rates when markets are already expecting it, said Jonathan Ernest, an economics professor at Case Western Reserve University’s Weatherhead School of Management.

Fed funds futures traders see an 80% chance the central bank will raise its benchmark lending rate by a quarter point on Wednesday. If the Fed didn’t follow through with the rate hike, it would startle markets and “lead more people to believe rates would go up in future periods,” said Ernest.

Fed wants to avoid ‘stop-and-go’ rate hikes

The Fed is raising interest rates to lower inflation. To do that, it has to intentionally slow parts of the economy by making it more expensive for banks, and thereby consumers, to borrow money.

But it’s a delicate balancing act between lowering inflation and causing a recession.

In the 1970s and early 1980s, the Fed flip-flopped between raising interest rates to get inflation under control and lowering rates to spur economic activity. This form of monetary policy, often referred to by economists as “stop-and-go,” was disastrous for the economy. The Fed wasn’t able to tame inflation or grow the economy.

Though inflation is cooling, it remains more than twice the Fed’s 2% target level. That’s why the central bank is focused on bringing inflation down above all else for the time being, said Ernest.

Service prices aren’t coming down as easily as goods

One reason the Fed is struggling to get inflation down is service prices aren’t responding well to rate hikes.

Service prices as measured by the Consumer Price Index are up 7.1% year over year. Meanwhile, prices across goods and services are up 5% year-over-year.

Prices for services are tougher for the Fed to influence because they are often tied to wages, which are up 5.1% from a year ago, according to the Employment Cost Index.

The Fed isn’t worried about a systemic banking crisis

If the Fed saw the recent bank failures as a systemic problem, it would most likely reconsider hiking rates again. But officials at the Fed haven’t expressed any of those concerns.

“One regional bank failure isn’t reason for the Fed to change its strategy,” Ernest told CNN. “It’s certainly shocking and causes flashbacks to [the financial crisis in] ’08,” he added, but so far there’s no reason to believe history will repeat itself.

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