U.S. central bank to announce latest interest rate decision Wednesday, amid banking crisis

U.S. central bank to announce latest interest rate decision Wednesday, amid banking crisis

The Federal Reserve is set to announce its latest interest rate policy Wednesday, a decision that is a much more in doubt than it was barely a month ago due to the smouldering crisis in the U.S. banking system.

Most economists who watch the U.S. central bank expect it to raise its trendsetting interest rate by another quarter of a percentage point, as part of its ongoing campaign to wrestle inflation into submission.

That would bring the U.S. interest rate to almost five per cent, its highest level in 16 years.

But the events in the financial sector during the past few weeks make that prediction much less of a sure thing.

Silicon Valley Bank (SVB) collapsed earlier this month, pushed into insolvency by a sudden bank run that saw depositors pull out billions of dollars from the bank in a matter of days, an exodus that the bank didn't have the funds to come up with.

The capital crunch that started at SVB was followed by the failure of another major bank, Signature Bank. A third, First Republic Bank, was saved from collapse by a $30 billion cash infusion. More are believed to be teetering.

Although the causes were disparate, they share a common theme: an inability to withstand the impact of higher interest rates, once investors and depositors became spooked by the banks' finances. SVB's problems began when it had to sell $20 billion worth of government bonds at a loss, because the Fed's rate hikes had made those older, lower-yielding bonds less desirable.

Inflation fight may come with a cost

Much like many central banks, the Fed has been hiking its interest rate in order to bring down inflation, which topped out at more than nine per cent last summer.

The most recent data suggests the official U.S. inflation rate has come down to six per cent. That's still twice as high as the U.S. central bank likes to see, so all things being equal, the Fed would normally have no qualms about raising it again.

But fears of a banking crisis may cause the central bank to be more cautious.

"Recent thinking has shifted to how much support the Fed may need to provide to shore up confidence in the U.S. banking system and avoiding a panic," said Colin Cieszynski, chief market strategist at SIA Wealth Management in Toronto.

As recently as two weeks ago, U.S. Federal Reserve Chair Jerome Powell was telling lawmakers that the central bank was willing to raise rates by as much as necessary to rein in inflation — words that investors interpreted as meaning a large 50-point hike was on the table.

But that was then and this is now. Traders on Wednesday were pricing in about a two-thirds chance of a small hike of 0.25 per cent. That means there's a one in three chance the Fed will stand pat. 

Futures markets even imply there's an expectation the Fed will actually have to cut rates as many as three times by the end of this year.

Treasury Secretary Janet Yellen told a banking conference on Tuesday that the situation is "stabilizing" and that the system "remains sound" but reinforced that the U.S. government will take whatever steps are needed to make sure depositors are safe.

Another rate hike would only increase the likelihood of a U.S. lender getting squeezed, which is why investors think its doubtful the Fed will put its money where its mouth is and raise interest rates much higher in order to snuff out inflation.

"It is a clear message from multiple officials that they are not taking this banking turmoil lightly and that they will probably be proactive when the next major risk arises," analyst Edward Moya with foreign exchange firm Oanda said.

The Fed is set to reveal its rate decision at 2 p.m. ET. Chairman Powell will explain the bank's line of thinking at a press conference following the announcement.