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Inflation
Macro and Market
General Investing

Fed Refuses to Flinch

Quarter-point rate hike may be the last as banking sector turmoil exposes cracks in U.S. financial system.

03/22/2023
United States Federal Reserve building.

Key Takeaways

The Fed’s 0.25 percentage point rate increase reinforced the Fed's near-term inflation-fighting focus.

Mounting risks to financial system stability suggest this rate hike may mark the end of the Fed’s year-long tightening cycle.

Recession appears imminent, underscoring the potential benefits of defensive portfolio positioning.

Rate Hike Served Dual Purpose

Amid growing concerns about U.S. financial system stability, the Federal Reserve (Fed) continued pursuing its inflation-fighting mandate. Policymakers raised interest rates another 0.25 percentage point on Wednesday, lifting the benchmark lending rate to a range of 4.75% to 5%. Short-term interest rates haven’t been this high since late 2007.

Recent bank failures led many Fed observers to question whether additional rate hikes were prudent. In our view, a quarter-point rate hike was appropriate for two reasons: It confirmed the central bank’s commitment to taming still-high inflation while signaling policymakers’ confidence in the U.S. financial system.

Just days before Silicon Valley Bank (SVB) and Signature Bank failed, Fed Chair Jerome Powell told Congress the pace of rate hikes might increase. He noted that recent stronger-than-expected economic data could prompt the Fed to lift rates higher than expected. Powell’s March 7 speech immediately led to market expectations for a half-point rate hike at today’s meeting and additional increases at future meetings.

In our view, not raising rates today would have sent the wrong message to financial markets. Quickly downshifting from an anticipated half-point rate hike to no increase could have amplified concerns about the U.S. financial system. It also could have damaged the Fed’s credibility if inflation becomes a bigger problem for the economy.

Fed Policy Reaches a Turning Point

Recent data suggests the economy has not yet felt the full effects of the Fed’s nine consecutive interest rate hikes. Inflation has steadily eased off June’s peak of 9.1%, but it remains much higher than the Fed’s target. The labor market has remained strong, and the overall economy has continued to grow.

However, we believe today’s rate hike may mark the end of the Fed’s aggressive year-long tightening cycle. While the Fed didn’t intend to trigger a banking crisis, the U.S. now faces one. And it’s likely to severely tighten financial conditions and force the Fed to reverse course later this year.

Credit Crunch May Accelerate Economic Slowdown

In the wake of several high-profile bank failures, the entire banking industry is now under intense scrutiny. We expect most banks to rein in their risk exposure and significantly tighten their lending standards. We also expect the resulting credit crunch to spread through the economy and stifle growth, cool inflation and ultimately trigger a recession.

Will the private sector be able to step up and provide the much-needed risk capital, or will the government be forced into launching another bailout?

Banking Crisis Complicates the Fed’s Focus

The Fed’s core responsibilities include promoting long-term price stability (2% average core inflation) and maximum employment. Achieving these goals requires financial system stability, which now appears in jeopardy due to the bank crisis.

Given the risks to the U.S. financial system, the Fed, Federal Deposit Insurance Corp. (FDIC) and Treasury Department took quick action after SVB’s collapse. The FDIC extended its insurance protection beyond the $250,000 limit, ensuring all SVB and Signature Bank depositors would lose no money. The Fed also created an emergency lending facility to help other banks shore up their cash positions.

These measures appear to have calmed the situation for now. But beyond immediate liquidity needs, small regional banks face challenges in their funding structure and credit risks in their commercial real estate exposure.

Some may encounter substantial capital shortages requiring a significant amount of capital infusion. Will the private sector be able to step up and provide the much-needed risk capital, or will the government be forced into launching another bailout?

In the meantime, the resulting economic slowdown should tame inflation, but not to pre-pandemic levels. In exchange, the Fed may confront a complex backdrop of above-target inflation, a harsh recession and banking system instability. This combination will challenge fiscal strategy, complicate Fed policy and potentially ignite a political firestorm.

Risk of Deeper Recession Rises

The still-unfolding banking/credit crisis will likely hasten the recession’s arrival and trigger a more-severe downturn than expected. It’s important to remember how we got here — and how far the economic pendulum swung in recent years.

The government’s $5 trillion in pandemic support and the Fed’s trillion-dollar quantitative easing program pushed the nation’s money supply to unprecedented levels. This dynamic and an extended period of ultra-low interest rates caused inflation to surge. The pendulum is now starting to swing back in the opposite direction, and we believe it's unrealistic to expect a soft landing.

Defensive Sectors May Offer Value

With recession risk growing, we believe a focus on higher-quality securities is warranted. Our investment teams have been anticipating an economic slowdown and positioning our portfolios accordingly.

Our fixed-income managers believe higher-quality securities, including U.S. Treasuries and higher-credit-quality corporate and securitized bonds, may help weather a recession. In addition, extending duration may deliver value, as interest rates typically fall as recession appears imminent.

Our equity team believes companies with higher profitability and healthy balance sheets merit consideration in today’s economic climate. Businesses in traditionally defensive sectors (utilities, health care, consumer staples) and dividend-paying stocks historically have offered value when the economy weakens. Additionally, companies with dependable, secular earnings growth tend to outperform in challenging economies.

Don’t Lose Sight of Your Long-Term Plan

As in all periods of market uncertainty, we encourage you to remain disciplined and focused on your long-term investment strategy and goals. Investing across multiple asset classes and focusing on risk management may be prudent in the current market climate.

It’s also important to remember that attractive investment opportunities often emerge during market unrest. We suggest investing with experienced professionals with the insights and discipline to recognize and potentially capitalize on such prospects.

Author
Charles Tan
Charles Tan

Co-Chief Investment Officer

Global Fixed Income

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Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.

Diversification does not assure a profit nor does it protect against loss of principal.