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What the Fed did and Why it Matters

In the meeting held on March 22, this was the big decision taken by the Federal Reserve (the Central bank or the RBI equivalent for the US).

Rate hike of 25 basis points (0.25 percent points) to 4.75-5% - exactly as I'd anticipated in my piece in Moneycontrol last week on the banking crisis.

Bond markets are pricing in just one more interest rate hike to 5.1% and then rate cuts in the second half of 2023.

Now for what Fed Chair Powell said in his press conference.

1. The Fed is NOT factoring in any rate cuts this year, in its base case.

2.  The Fed still has target of 2% inflation as its Central Goal & will not stop without that in sight, which is still some way away.

The question: What'll the Fed do from hereon?

3. The exact rate trajectory will depend on data. For example, between the last meeting & this one the Fed first anticipated more tightening as the inflation did not drop enough and the labour market remain tight.

But the banking crisis changed that resulting in the lower hike.

The important data point?

4. Till now inflation has moderated only for goods and housing, the non-housing services inflation remains sticky.

Hence, as I've mentioned before, the low-hanging fruit on inflation is already in.

The rest of it won't come easy!

So, what could be the possible reason(s) for the Fed to ease off a bit?

5. The short answer: post the banking crisis, credit conditions have been tightening.

These work in ways similar to what's achieved by interest rate hikes: slowing growth, inflation & labor markets.

Going forward the hikes will depend on how much credit tightening achieves.

In other words, if it causes enough of a slowdown on its own, the Fed may not need to do as much in terms of hiking rates.

6. BUT, whether it is achieved through credit tightening or monetary policy, the Fed is determined not to stop till inflation is tamed.

That much was clear from the presser.

Chair Powell tried to minimize speaking on details of the banking crisis, saying investigations to find causes were underway, but here are the nuggets from what he did say.

7. On Silicon Valley Bank (SVB), the regulator had identified the interest rate risk but while they were still talking to the bank the deposits flew out at an unprecedented rate.

Please see footnote on where I think the regulators took their eyes off the ball.

8. Regulators have to come to terms with internet speed and the mismatch of banks allowing withdrawals 24x7 & Central Bank lender of last resort windows being open on the old banking schedule becaming the last straw that broke the SVB back.

Basically, when SVB tried to borrow against its investment book in order to meet the demand for deposits, the Fed window had closed for the day!

Will do a separate piece on the details of this.

9. Since Janet Yellen, Treasury Secretary, said that FDIC will not guarantee all deposits, this may introduce further uncertainty in the banking system.

That's the part I am personally worried about.

Obviously the managements of regional banks, like Silicon Valley Bank (SVB), should've managed the risks on the investment book better than they did, but what about the regulators?

THEY knew that this kind of interest rate hike was beyond the career memory of about 95% of the bankers and other market participants.

Plus unlike credit risk, where the regulator cannot know the quality of the book without considerable digging, this is an easily modelable problem.

The quantum of outstanding fixed income securities is known and I suppose roughly where they are held is also known.

So the regional bank investment book risk should have been a very easily foreseeable problem.

Of course, there were lots of ways this exposure could and should have been hedged by the bank(s) managements themselves.

Also, as we all know, for most banks, rising rates are a positive because the interest rates on credit assets (loans, credit lines etc) are increased immediately whereas the deposit rates are hiked much more slowly.

Thus, rising rates are usually margin positive for banks.

Hence, the Central banks may not have worried too much about the fallout of their rapid rate hikes on banks... But they should have been aware that not every bank has a similar sort of Asset Liability book.

SVB was in a peculiar position (as explained in my earlier Moneycontrol article) where rates were a double whammy for them, unlike for credit oriented banks.

Higher rates brought down their asset (investment) value, even as it effectively dried up deposits, as its customers (the startup ecosystem) could no longer raise funds easily.

Even so, in my opinion, the asset side problem should have been on the regulatory radar as with the rapid rise in rates, somewhere in the system, somebody was obviously going to be taking a hit, as a direct result of their own actions.

That it would be a never before seen phenomena for most market participants should have been a further warning sign for regulators.

To some extent, they were also caught sleeping.

Agree? Or not?

Of course, second order impact of rising rates can be in the form of higher delinquencies/ poorer asset quality.

But that's a topic for another day.

From the desk of 

Devina Mehra

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