Will the Banking Sector Meltdown Get the Fed to Slow Down on Interest Rate Hikes?

It's a tough call for the Fed as it works to battle inflation.

Silicon Valley Bank's collapse earlier in March has left the banking industry reeling. It's also left consumers wondering whether their savings are really as safe as they thought.

But it's not just SVB that's causing upheaval. First Republic Bank got a $30 billion bailout last week in an effort to avert a massive banking industry crisis. And it's not the only bank whose finances are precarious right now.

Higher interest rates have been putting a strain on banks, many of which invest in bonds. When interest rates rise, bond values tend to drop. SVB was forced to sell bonds at a massive loss when trouble hit, leading to panic and a run on the bank. But if more banks are forced to follow suit, the industry as a whole could really take a tumble.

Meanwhile, the ball's in the court of the Federal Reserve on the interest rate front, and up until a couple of weeks ago, there was reason to believe the Fed would keep pushing its interest rate hikes to slow the pace of inflation. But now, the central bank has a conundrum.

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If the Fed keeps raising rates, it will put more pressure on banks. If it doesn't, inflation might remain stagnant or increase.

It's a tough call. And it's one the Fed will have to address this week when it meets on March 21 and 22.

No easy answer

Inflation has been battering consumers for months, forcing many people to rack up credit card debt and raid their savings just to stay afloat. If the Fed doesn't intervene by raising interest rates, the U.S. could end up with a major debt crisis on its hands. But if interest rates keep going up, a banking crisis could ensue. As such, the Fed now finds itself between a rock and a hard place.

A compromise could work

The Fed's last interest rate hike was a 0.25% increase. That's a fairly moderate one, and it's a route the central bank might opt to take this week as well.

The Fed needs to slow inflation down. As of February, it was still up 6% on an annual basis, as measured by the Consumer Price Index.

A more aggressive rate hike could result in a world of backlash. But if the Fed doesn't raise rates at all, it might really send the wrong message -- and drive inflation in the wrong direction.

The Fed's goal right now is to bring inflation down as close as possible to the 2% mark. As the Fed says itself, over the long run, 2% inflation is most consistent for maximum employment and price stability. "When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy."

That sounds perfectly reasonable. But since we're a long way from 2% inflation, it's fair to assume that the Fed is not going to back down on rate hikes this week. That's something borrowers and consumers with money in the bank alike will want to pay attention to.

The good news is that consumers are protected in the event of a bank failure for up to $250,000 at FDIC-insured institutions. But even so, a complete banking industry collapse wouldn't be good for anyone. So let's hope the Fed doesn't drive the industry closer to that point.