Powell’s balancing act raises some questions

The Federal Reserve’s decision to raise interest rates by 25 basis points this week split the difference between the bigger increase it signaled earlier this month and the pause that many demanded because of alarm over distressed banks. Under testing circumstances, the modest increase in the policy rate to a range of 4.75% to 5% is a defensible compromise. Even so, cracks are showing in the central bank’s reasoning.

The Fed had to balance two risks. The first was that maintaining a firm pace of monetary tightening would deepen the recent turmoil, lead to a further unintended tightening of financial conditions, and cause demand to fall abruptly. The other was that keeping rates on hold, at least for now, would lead investors to doubt the Fed’s determination to get on top of inflation.

Things might change, but at the moment entrenched inflation is the greater danger. And to curb inflation, the central bank needs to convince markets that financial stability and macroeconomic policy are separate tasks requiring different tools. Interest rates should be set according to macroeconomic conditions. Financial stability is best addressed by the kind of measures the Fed has already deployed — mainly by providing emergency liquidity, if needed, to fundamentally sound institutions.

Though the compromise on rates is understandable, it calls this necessary division of labor into doubt.

In his remarks on Wednesday, Chair Jerome Powell maintained that the Fed loses nothing by moderating its anti-inflation strategy until it has a clearer view of where things are headed. He emphasized that the banking turmoil has tightened financial conditions regardless of what happens to the policy rate, substituting for the bigger increase the Fed previously had in mind. Later this year, if monetary tightening is still needed, it will resume — as the central bank’s dot plots predict. For now, Powell said, a smaller increase in rates and the stress-induced tightening of financial conditions will keep pressing down on prices.

This logic is plausible but flawed. The Fed can’t credibly promise to raise rates later if it’s too easily deflected by doubts about where things are heading. (The so-called “hawkish pause” — timidity now, determination later — is a contradiction in terms.) And the supposed tightening due to financial uncertainty is probably exaggerated. Short-term credit spreads and measures of volatility rose sharply in the immediate aftermath of the Silicon Valley Bank collapse, but investors are also placing bets that the Fed will ease up on interest rates. The net effect is unclear.

To be sure, it was wiser to raise rates by 25 basis points than by nothing. Aside from the damage to the Fed’s credibility on inflation, no increase at all might have scared financial markets more than pressing on, leading investors to think policymakers are more worried about financial fragility than they’re admitting. Plainly, the

Fed is grappling with enormous uncertainty. What happened to SVB, Credit Suisse and the others raises big, urgent questions about bank regulation and the adequacy of central banks’ emergency-liquidity tools. The damage may spread. Renewed turmoil is possible. If things get bad enough, demand could indeed slump. In this worst-case scenario, the Fed will need a whole new set of dot plots.

All that could happen. But high inflation -—the biggest problem the economy faces — is not a hypothetical issue: It’s here and now. If the Fed is suspected of flinching, it will become very much harder to solve.