In the shadow of the recent turbulence in the banking sector, the US Federal Reserve will decide on the key interest rate on Wednesday. The banking crisis surrounding the Silicon Valley Bank is likely to be an obstacle to further significant interest rate hikes. The sharp rise in interest rates is considered one of the reasons for the problems in the American banking sector.

The Federal Reserve will announce its decision in the evening (7:00 p.m. CET) and will also publish an updated economic forecast. It now has to weigh up between calming concerns in the banking sector and fighting high consumer prices.

situation is now more complex

While a significant interest rate hike was still considered likely a few weeks ago, following the collapse of several US banks it is unclear which path the Fed will take. In February, the central bank of the world’s largest economy raised its key interest rate by 0.25 percentage points to a range of 4.5 to 4.75 percent.

Central Bank President Jerome Powell had made it clear at the beginning of March that further large interest rate hikes were possible. But now the situation is more complex. In view of the high inflation, a further interest rate hike is considered likely – but at a slow pace. An increase of 0.25 points is expected, and some experts do not rule out a pause in interest rate hikes.

The trigger for the crisis at the beginning of March was the liquidation of the US financial group Silvergate Capital, which is geared towards the crypto industry. A few days later, the US money house Silicon Valley Bank, which specializes in start-up financing, was placed under the control of the US deposit insurance company FDIC and closed. It was the largest collapse of a US financial institution since the 2008 financial crisis. It was followed by the closure of Signature Bank and a coordinated rescue effort for another struggling financial institution in the USA.

Nervousness in the banking industry

In Europe, the major Swiss bank Credit Suisse ran into serious problems. After numerous scandals, criticism of poor risk management and cash outflows in the three-digit billion range, the bank had its back to the wall at the weekend. The share price had crashed despite liquidity promises. In order to prevent a conflagration and a global financial crisis in view of the nervousness in the banking industry, the government and supervisory authorities pushed the competitor UBS to take over.

The so-called interest rate risk is at the heart of the banking crisis. For example, the Silicon Valley Bank had invested enormous sums in long-term and low-interest bonds, which are actually among the safest investments on the financial market. However, since the US Federal Reserve raised the key interest rate so quickly and significantly in the fight against high inflation, this portfolio lost value drastically. This got the balance sheet out of control and ultimately triggered an immense withdrawal of customer funds due to liquidity concerns.

Worry about the risk of infection

In response, six major central banks, including the Fed and the European Central Bank (ECB), increased their rate of providing dollar liquidity to the financial system. The US government also made it clear on Tuesday that it would mobilize further aid for ailing banks if necessary. Treasury Secretary Janet Yellen defended previous support measures. At the same time, she held out the prospect of further support and emphasized that the government considered similar measures to be appropriate if there was a renewed flight of deposits and the risk of contagion for the rest of the financial sector.

The Fed now has to show that it takes the turbulence in the banking sector seriously – but at the same time is not letting up in the fight against high consumer prices. High inflation in the USA is continuing to weaken. In February, US consumer prices increased by 6.0 percent compared to the same month last year. It’s the lowest increase since September 2021. However, that’s a far cry from the target inflation rate of 2 percent on average.

Strong US job market a problem

Keeping inflation in check is a classic task for central banks. If interest rates rise, private individuals and the economy have to spend more money on loans – or borrow less money. Growth is slowing, companies cannot simply pass on higher prices – and ideally the inflation rate is falling.

Another problem for the Fed is the strong US labor market. Because if there is a shortage of workers in important sectors, this can boost prices. Unemployment in the US rose surprisingly in February. It increased to 3.6 percent – but was still at a low level.

Despite the uncertainty in the banking sector, the European Central Bank (ECB) decided last week to raise the key interest rate significantly by 0.50 percentage points to 3.5 percent. In the US, meanwhile, some are already betting that the Fed could start lowering interest rates starting in the summer.