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Wall Street split on Fed's next move as financial sector buckles after bank failures

Wall Street economists are split on whether the collapse of Silicon Valley Bank (SIVB) will alter the Federal Reserve's plans to raise interest rates later this month as the central bank now manages a financial panic alongside stubborn inflation.

Economists at Goldman Sachs led by Jan Hatzius kicked off the debate in a note to clients late Sunday that said the firm now expects the Fed won't raise rates at the conclusion of its next policy meeting on March 22.

"In light of recent stress in the banking system, we no longer expect the FOMC to deliver a rate hike at its March 22 meeting with considerable uncertainty about the path beyond March," wrote analyst Jan Hatzius.

"We have left unchanged our expectation that the FOMC will deliver 25bp hikes in May, June, and July and now expect a 5.25-5.5% terminal rate, though we see considerable uncertainty about the path."

Markets are currently pricing in a ~70% chance the Fed raise rates by 25 basis points at its March 22 policy meeting with a ~30% chance the Fed leaves rates unchanged, according to data from the CME Group.

Economists at Barclays, in contrast, reiterated their call for a 50 basis point hike next week, though the firm cautioned "more signs of distress linked to Silicon Valley Bank could make the FOMC more cautious." The Fed's benchmark interest rate is currently set at a range of 4.5%-4.75%.

The financial sector was under pressure early Monday with smaller regional banks bearing the brunt of the selling pressure as investors fear other firms may face the same fate as SVB, Signature Bank (SBNY), and Silvergate (SI).

The government's announcement late Sunday all SVB depositors would be made whole also noted Signature Bank had also been seized by regulators, which took over SVB Friday morning. Silvergate announced plans to liquidate and wind down operations last week.

SVB and Signature's failures mark the second- and third-largest bank failures in U.S. history, respectively.

EY chief economist Greg Daco wrote in a note to clients on Monday the Fed will likely raise interest rates by 25 basis points given instability in the financial system resulting from these bank failures.

"Our view is that recent developments will likely favor a smaller 25bps rate hike at next week’s FOMC meeting, but we should not be too quick to dismiss the possibility of a 50bps rate increase," Daco wrote. "Extreme data dependence means that policymakers will consciously, or subconsciously, continue to look confirmation of their priors in economic data."

Elsewhere on Monday, economists at Bank of America reiterated a call for the Fed to raise interest rates by 25 basis points on March 22 following this weekend's events.

On Tuesday morning, key inflation data for February will likely solidify in the minds of investors and economists the magnitude of the Fed's next step. Expectations are headline inflation will rise by 6% over last year, which would be the slowest annual increase since September 2021, but still three times higher than the Fed's 2% inflation target.

Ahead of last week's bank failures markets had assigned a probability as high as 60% of a 50 basis point increase from the Fed next week.

Still, the Fed's focus on inflation and the labor market in setting policy will be put to a unique challenge next week as the central bank manages its so-called "third mandate" of financial stability.

"We believe [these] events should not have significant broader implications for the economy and are not a sign of systemic risks to the banking sector," Oxford Economics analyst John Canavan wrote in a note to clients on Monday. The firm sees the market reaction to financial sector instability arguing in favor of a 25 basis point increase from the Fed next week.

"The aggressive pace of rate increases has also been the major factor behind our forecast of a recession later this year," Canavan added.

"Our view has been that, in order to put a stake through the heart of inflation, the FOMC is prepared to tighten until it breaks something. The SVB collapse and the seizure of Signature Bank are signs of that beginning to happen."

Federal Reserve Chair Jerome H. Powell testifies before a House Financial Services hearing on
Federal Reserve Chair Jerome H. Powell testifies before a House Financial Services hearing on "The Federal Reserve's Semi-Annual Monetary Policy Report" on Capitol Hill in Washington, U.S., March 8, 2023. REUTERS/Kevin Lamarque

Alexandra Canal is a Senior Entertainment and Media Reporter at Yahoo Finance. Follow her on Twitter @alliecanal8193 and email her at alexandra.canal@yahoofinance.com

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