The Fed Will Keep Tightening

Rates will continue to rise, SVB and other bank troubles notwithstanding

A security guard at the failed Silicon Valley Bank monitors a line of people outside the office in Santa Clara, Calif., on March 13, 2023. Justin Sullivan/Getty Images

Commentary

With the failures of Silicon Valley Bank (SVB) and Signature Bank, much of the financial community seems to think that the Federal Reserve will try to ease financial pressures by softening its counter-inflationary policy posture. The Atlanta Fed’s market probability tracker showed a dramatic downward adjustment in people’s expectations of interest rate increases.

Perhaps some such concern over the fallout from the failures might even have led the Fed to raise the benchmark federal funds rate by only 0.25 percentage points this last time, much less aggressively than it had previously. Even if this is so, the Fed generally has nonetheless made clear that inflation isn’t abating sufficiently and that counter-inflationary moves will dominate going forward. Interest rates will continue to rise.

In one respect, the Fed might even view the bank failures as an aid in its fight against inflation. Certainly, the fear of a run on deposits will instill in bankers a new caution in their lending practices, and that, in turn, will slow the flow of credit into the economy. And it’s a slowdown in credit flows that is the bottom line of the Fed’s effort to contain inflation.

Rising interest rates are simply a means to that end. Bank caution serves the Fed’s purpose.

Indeed, just such a trend was developing even before the news of SVB’s failure. The Fed’s February survey of bank practices, called “The Beige Book” and compiled before the news on SVB, showed a tightening of lending standards and a slowdown in borrowing and lending. Policymakers could have as easily taken this picture as a reason to slow the pace of interest rate hikes as any effort to help the system deal with the fallout from SVB and Signature. In any case, that fallout will only exaggerate this pattern and so reinforce the Fed’s counter-inflationary efforts.

Whatever the trends tracked by “The Beige Book” and the likely fallout from recent bank failures, the Fed will continue a primary focus on inflation trends. In this regard, a crucial indicator is the Fed’s forecasting tool, the “price pressure measure.” Produced by the St. Louis Fed, it combines several key inflation measures—including the Labor Department’s consumer price index and the Commerce Department’s consumer price deflator—to determine the probability that inflation over the coming 12 months will exceed the Fed’s informal target of 2.5 percent a year.

This measure first began to rise early in 2021, a good forecast of the inflation that emerged with a vengeance in 2022. The index reached its high in spring last year, showing a 97 percent probability of excessive inflation. The measure has come down a bit since then. Still, it remains elevated, showing more than an 80 percent probability that inflation will remain unacceptably high. That’s reason enough for the Fed to stick to its counter-inflationary policy posture and intensify it.

On a still more fundamental level are the Fed’s direct readings of ongoing inflation rates. To be sure, the analysts who inform policy look deeper than the headlines, but most of their refinements only confirm what is apparent in the headlines—that inflation remains a problem. One measure that has recently taken on prominence at the Fed—the “sticky-price inflation index”—makes this fact plain.

Economists have long tried to purge the regularly reported inflation measures of misleading distortions. The “core” measure excludes food and fuel prices. This is not because they are unimportant. On the contrary, food and fuel constitute about a fifth of the average household budget. Analysts look behind them because their volatility from month to month can easily give a misleading picture of underlying conditions. This “core” measure shows ongoing inflation at 5.5 percent a year. The newer “sticky-price core” excludes, in addition to some food and fuel prices, other areas where prices change frequently. It shows underlying inflation of more than 6 percent.

Either way, the Fed can’t get away from the fact that inflation is unacceptably high and demands a policy response, whatever else is happening. Policymakers can make their choice. They can look at their preferred forecasting tool, the “price pressure measure,” or monthly headline figures in the media. They can turn to the “core” inflation measure or the new “sticky-price core,” and the message is the same. They must stick to their counter-inflationary posture and raise interest rates further or admit they are ready to abdicate their responsibility.

It’s doubtful that Fed Chair Jerome Powell wants to walk away from his responsibilities or that the others at the Fed would let him even if, as is unlikely, he were so inclined.