Despite Bank Failures, Economist Says Fed Must Still 'Create Or Tolerate Tighter Financial Conditions' To Beat Inflation

The Federal Reserve's upcoming March meeting could be the next major catalyst for the SPDR S&P 500 ETF Trust SPY.

Growing investor concerns about instability among U.S. banks have some traders speculating the Fed could pause its rate hikes next week, but Bank of America economist Ethan Harris said Friday that financial conditions must get tighter one way or another.

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The Fed is in an extremely difficult situation, pressed to choose between maintaining interest rates after February CPI inflation came in at 6% or raising interest rates just two weeks after the failure of U.S. banks SVB Financial Group SIVB, Signature Bank SBNY and Silvergate Capital Corp SI.

The underlying CPI data, including pricing on auto and nonauto consumer products, is still far too high for the Fed to consider its job done at this point, the economist said. 

The U.S. economy added 504,000 jobs in January and 311,000 jobs in February, and payrolls have exceeded economist estimates for 11 consecutive months at this point.

"None of this guarantees a rate hike at next Wednesday’s meeting, but the natural path forward is for the Fed to create or tolerate tighter financial conditions until the labor market cools," Harris said. 

Related Link: How Have Bank Failures Impacted The Outlook For Interest Rates?

Given the inflation and labor market situation, Harris said that if the Fed opts not to raise rates in March, investors shouldn't assume rates have reached their terminal level.

It's not unusual for the Fed to prioritize financial stability in the short-term before returning to a longer-term outlook once the economy is on more stable footing, he said. 

Benzinga's Take: The most likely outcome at this point seems to be that the Fed will bite the bullet and continue with another 0.25% interest rate hike next week. Yet the bond market is pricing in a 26.9% chance of no rate hike next week, according to CME Group.

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