Exactly one year after launching its tight monetary policy campaign, the Federal Reserve faces a dilemma: continue its fight against inflation or reassure and stabilize the banking sector. 

The first mistake was President Jerome Powell’s enthusiasm in labeling 2021’s inflation signs as “transitory .” Despite extraordinary fiscal stimulus and robust economic recovery, he refrained from cutting off the quantitative easing tap, leaving interest rates near zero. Mortgage rates below 3% further stimulated an already strong housing market, cryptocurrencies, and speculative tech stocks soared, and, of course, consumer prices have ballooned as they haven’t in four decades. 

Powell obviously didn’t create inflation. It resulted from pandemic-related shortages and was exacerbated by the Ukraine war. But his late diagnosis effectively scuppered any possibility of the Fed offering a relatively painless solution. To catch up, the central bank had to raise rates at a pace never seen in the modern era of the institution, and the past few weeks have started to show the consequences of this race. 

Last week’s run on Silicon Valley Bank, a mid-sized bank specializing in venture-backed startups, has sent financial markets and depositors into a tizzy. The KBW Bank index has lost a quarter of its value over the past seven trading sessions. The ICE BofA MOVE index, a measure of bond market volatility, is flirting with levels seen after the Lehman Brothers collapse. The Credit Suisse saga, a bank already weakened, compounded this. The episode reinforces investor distrust. 

Historically, the Federal Reserve doesn’t generally raise rates without triggering a recession. This time it has raised rates 450 basis points in less than a year, and history suggests the effects will start to be felt from now and will build up next year. Moreover, these questions have arisen in an unchecked inflation context. Tuesday’s report showed that the core consumer price index is still rising by 5.5%. We’re still far from the goal, with the current target range of 4.5%-4.75%. Yet, many investors are betting on the end of this rate-hike cycle, even though policymakers will start cutting rates by the summer. 

There are several reasons why this assessment will likely prove wrong. First, it would invite comparisons to Arthur Burns, the Federal Reserve president of the 1970s, who gave up on his fight against inflation too soon, allowing price increases to become entrenched in the economy. 

Such a move would undermine Powell’s austerity speeches and risk damaging the Fed’s credibility to fight inflation for years. 

Second, history shows that the Federal Reserve generally does not change course so quickly. If the Fed would pause and start cutting by July, as the fed funds futures are now predicting, it would match the fastest U-turn in the modern era of monetary policy. Reversing direction would be a de facto admission that they were wrong. Over the past 30 years, the swiftest about-face came in 1995, when the Fed had left its rates at the highest for only five months. 

It still seems premature to conclude that the central bank will halt its rate-hike campaign. For nearly twelve years, money has flowed freely, inflating central bank balance sheets and giving investors bad habits. We have shifted into a new world where inflation is here to stay and where rates will remain elevated for an extended period.