WASHINGTON -- Still grappling with persistently high inflation, the Federal Reserve faces an entirely new -- and in some ways conflicting -- challenge as it meets to consider interest rates this week: How to restore calm to a nervous banking system.
The two simultaneous problems would normally push the Fed in different directions: To fight elevated inflation, it would raise its benchmark rate, perhaps substantially, for the ninth time in the past year. But at the same time, to soothe financial markets, the Fed might prefer to leave rates unchanged, at least for now.
Most economists think the Fed will navigate the conundrum by raising rates by just a quarter-point when its latest policy meeting ends Wednesday. That would be less than the half-point jump that many economists had expected before the recent collapse of two large banks. But it would still mark another step by the Fed in its continuing drive to tame inflation.
"You lose time on the fight against inflation if you wait," said Michael Feroli, the chief U.S. economist at J.P. Morgan. Still, Feroli had expected the Fed to raise its forecast for how high it would nudge rates this year, and he now expects them to leave their peak rate estimate unchanged at about 5%. But a few thought the Fed would hit pause, including economists at Goldman Sachs.
"While policymakers have responded aggressively to shore up the financial system, markets appear to be less than fully convinced that efforts to support small and midsize banks will prove sufficient," David Mericle at Goldman Sachs wrote in a preview. "We think Fed officials will therefore share our view that stress in the banking system remains the most immediate concern for now."
Economists at Barclays suggested that recent economic data would probably have prodded the Fed to opt for a larger half-point rate increase, all else equal. But given the continuing bank problems -- and the fact that Silicon Valley Bank's distress was partly tied to higher interest rates -- they expected the Fed to move by a quarter-point at this meeting to avoid further unsettling banks.
"The link between the rising funds rate and risks of further bank distress presents a clear tension for the FOMC," economist Marc Giannoni and his colleagues wrote, referring to the Fed's policy-setting Federal Open Market Committee. "Risk management considerations will warrant a less aggressive policy hike in March."
Some economists predict an outright rate cut in response to the upheaval, as the central bank waits to gauge the severity of the economic and financial fallout.
If the Fed were to lower rates or leave rates alone, which some analysts last week had suggested it might do given the banking turmoil, it could alarm Wall Street traders by suggesting that significant problems remain in the banking system.
"The Fed still wants to raise rates a bit more," said David Donabedian, chief investment officer of CIBC Private Wealth US. "It's just a matter of whether the banking system volatility will let them."
Vincent Reinhart, a former top Fed economist now at the investment bank Dreyfus-Mellon, noted that the central bank prefers to manage financial stability issues separately from its rate decisions. One goal of a series of emergency steps the Fed announced Sunday to bolster the banking system is to allow it to separately address inflation through its rate policies.
"If you are obviously seen as adjusting your monetary policy because of concerns about financial strain, then you're admitting you're not [successfully] doing ... crisis management," Reinhart said.
Last week, the European Central Bank imposed a half-point rate increase to try to reduce an 8.5% inflation rate despite jitters caused by the struggles of Switzerland's second-largest lender, Credit Suisse.
"This is not going to stop our fight against inflation," Christine Lagarde, the president of the European Central Bank, said in a news conference March 16. She added that officials "don't see any trade-off" between pushing for price stability and financial stability, and that central bankers had separate tools to achieve each.
That sort of message could be one the Fed wants to emulate, Feroli said. Yet there are key differences in the United States, where there have been outright bank failures and where Fed rate moves have been part of the stress causing the turmoil.
Diane Swonk, the chief economist at KPMG, said she did not think the European Central Bank's actions would serve as a road map for the Fed "given that the road is shifting as we speak," and she expected policymakers to hold off on a rate move this week.
"At this point in time, for the Fed, a pregnant pause is warranted," she said. "It's a marathon, not a sprint -- hold back now, promise to do more later if needed."
On Sunday, the Swiss banking giant UBS bought troubled Credit Suisse for $3.25 billion in a deal orchestrated by banking regulators to try to prevent potentially calamitous turmoil in global markets.
The Fed intervened in the banking emergency a little over a week ago by joining with the Treasury Department and the Federal Deposit Insurance Corporation to announce that the government would protect all of the banks' deposits. It also unveiled an expansive emergency lending program to provide ready cash for banks and other financial institutions. And it sweetened the terms for the banks to borrow from a long-standing Fed facility known as the "discount window."
On Thursday, the Fed said it had lent nearly $300 billion in emergency funding to banks, including a record amount from the discount window.
Assuming that those programs work as intended, the Fed can focus on its ongoing campaign to cool inflation. Most recent economic reports point to a still-hot economy with strong hiring, steady consumer spending and persistent inflation.
Consumer prices rose 6% in February from a year earlier, down from a peak of 9.1% last June. Most of that decline reflected a shift in consumer spending away from goods -- such as used cars, furniture and appliances, which have been falling in price -- and toward services, including traveling, dining out and entertainment events.
That spending surge has kept inflation high in services categories, which Federal Reserve Chairman Jerome Powell has singled out as a major concern because inflation tends to be particularly persistent in services.
"Inflation -- it's still got some legs, unfortunately," said Nathan Sheets, a former Treasury official and Fed economist, now chief global economist at Citi. "The labor market is still booming."
Hiring and inflation figures accelerated earlier this year after having shown signs of cooling in late 2022. In response, Powell and other Fed officials suggested that the central bank would likely raise rates higher than they had forecast in December and probably keep them at a peak for longer.
When the Fed raises its key rate, it typically leads to higher rates on mortgages, auto loans, credit cards and many business loans. Typically, consumer and business spending slow in response.
"The recent data indicate that we haven't made as much progress as we thought," Christopher Waller, a member of the Fed's Board of Governors, said this month. The Fed's efforts to reduce inflation to its 2% target, Waller said, "will be slower and longer than many had expected just a month or two ago."
The banking troubles have also intensified fears among many economists that the economy could soon tumble into recession.
One reason for the pessimism is that some banks will likely curtail lending to help shore up their finances and avoid running the risk of a collapse. Economists at Goldman Sachs estimate that credit tightening by the banking sector could reduce economic growth this year by as much as a half-percentage-point.
Ironically, though, that slowdown in growth could help the Fed, which has had only limited success in trying to cool the economy through its rate increases.
The potential slowdown in lending "is going to do some of the Fed's work for it," John Roberts, a former Federal Reserve economist, said. "So the Fed won't have to raise rates as high as otherwise."
Information for this article was contributed by Christopher Rugaber of The Associated Press, Jeanna Smialek of The New York Times and Abha Bhattarai of The Washington Post.