The Federal Reserve’s decision to raise the target federal funds rate by 0.25% has been complicated by the collapse of Silicon Valley Bank, Signature Bank, and broader international financial volatility. Tighter credit conditions resulting from these developments could have negative effects on economic activity, hiring, and inflation.
Nonetheless, the decision to increase interest rates was based on recent indicators showing moderate growth in spending and production, strong job gains, and low unemployment rates despite inflation remaining elevated at 6.0% as of February 2023. During the pandemic-induced recession, interest rates were set at 0.0% to 0.25% to stimulate economic activity, but they now range between 4.75% and 5.0%.
The purpose of rate hikes is to reduce inflationary pressures by making it more expensive to borrow money, thereby encouraging consumers and businesses to take on less debt. However, the collapse of Silicon Valley Bank and Signature Bank has complicated the decision to raise interest rates. Silicon Valley Bank was forced to sell a bond portfolio at a loss due to the higher interest rate environment, causing account holders to withdraw their funds. Fortunately, the Federal Deposit Insurance Corporation insured all accounts to prevent bank runs at other firms.
The Federal Open Market Committee believes the financial system is resilient but acknowledges that recent developments are uncertain and could have far-reaching consequences. According to one study, the Federal Reserve’s more restrictive monetary policy has caused bank assets’ value to decrease by 10%, making banks more vulnerable to runs from uninsured depositors.
Federal Reserve Chair Jerome Powell stated that the robust labor market and persistent inflation in certain areas mean policymakers will gradually increase target interest rates. However, household wages have declined over the past two years, even with low unemployment rates.