Challenging the Fed

As the Federal Reserve convenes to consider interest rates this week, it faces a new challenge in addition to grappling with persistently high inflation: restoring calm to a nervous banking system. The Fed must balance two conflicting issues, namely fighting elevated inflation by raising its benchmark rate and soothing financial markets by leaving rates unchanged. While some analysts suggested that the Fed might choose to leave rates alone due to the recent collapse of two large banks, most economists expect the Fed to navigate the conundrum by raising rates by just a quarter-point, which would mark another step in its continuing effort to tame inflation.

Vincent Reinhart, a former top Fed economist now at the investment bank Dreyfus-Mellon, explained that the central bank prefers to manage financial stability issues separately from its rate decisions. To address inflation through its rate policies, the Fed announced a series of emergency steps to bolster the banking system. These steps include allowing the Fed to manage financial stability issues independently of its rate decisions. Last week, the European Central Bank raised its rate by half a point to reduce an 8.5% inflation rate despite the struggles of Switzerland's second-largest lender, Credit Suisse. ECB President Christine Lagarde said she saw "no tradeoff" between fighting inflation and preserving financial stability.

Assuming that the Fed's emergency programs work as intended, the central bank can focus on its ongoing campaign to cool inflation. However, recent economic reports indicate a still-hot economy with strong hiring, steady consumer spending, and persistent inflation. Consumer prices rose 6% in February from a year earlier, and most of the decline from the peak in June 2022 reflected a shift in consumer spending from goods to services, which have kept inflation high in service categories. Fed Chair Jerome Powell has singled out inflation in services as a major concern because it tends to be particularly persistent. Powell and other Fed officials suggested earlier this year that the central bank would likely raise rates higher than they had forecast in December and probably keep them at a peak for longer.