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The recent collapse of Silicon Valley Bank and Signature Bank has complicated the Federal Reserve’s decision to announce a 0.25% increase in the target federal funds rate. These two failed banks have made the decision to hike interest rates more complex. 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. Despite this, the Federal Deposit Insurance Corporation insured all accounts to prevent bank runs at other firms.
The collapse of these two banks comes at a time of broader international financial volatility, which is likely to result in tighter credit conditions. This could affect economic activity, hiring, and inflation. The Federal Reserve’s more restrictive monetary policy has caused bank assets’ value to decrease by 10%, making banks more fragile to runs from uninsured depositors.
Despite these challenges, the decision to raise interest rates was based on recent indicators showing moderate growth in spending and production, strong job gains, and low unemployment rates. However, inflation remained elevated at 6.0% as of February 2023. During the pandemic-induced recession, interest rate targets were set between 0.0% and 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 increasing the cost of borrowing money, leading consumers and businesses to take on less debt. Federal Reserve Chair Jerome Powell has stated that the robust labor market and persistent inflation in certain areas mean that policymakers will continue to increase target interest rates gradually. However, household wages have declined over the past two years, even with low unemployment rates.
The Federal Open Market Committee believes that the financial system is resilient but recognizes that recent developments are uncertain and could have far-reaching effects. Despite the challenges posed by the collapse of Silicon Valley Bank and Signature Bank, the Federal Reserve will continue to monitor economic indicators and adjust monetary policy as needed to maintain price stability and promote sustainable economic growth.
