Exactly a year into its campaign of monetary policy tightening, the Federal Reserve faces its toughest set of choices yet: It can forge ahead with its inflation fight or pivot to address growing banking-sector fears. Behind Door No. 1: an ever-approaching recession. Behind Door No. 2: entrenched inflation.

Unfortunately, it’s looking like a lose-lose scenario of policymakers’ own making.

The original mistake, of course, was Chair Jerome Powell’s eagerness to dismiss the signs of inflation in 2021 as “transitory.” Even in the face of extraordinary fiscal stimulus and a strong economic recovery, he refrained from turning off the quantitative easing spigot and left interest rates near zero until inflation measured in the consumer price index was near 8%. An already hot housing market was goosed by mortgage rates below 3%; speculative cryptocurrencies and tech stocks were allowed to run wild; and, of course, consumer prices inflated as they hadn’t in four decades.

Powell clearly didn’t create the inflation — it was born out of the pandemic shortages and then exacerbated by the war in Ukraine — but his late diagnosis effectively torpedoed any chance that the Fed ever had of delivering a relatively painless solution. To catch up, the Fed had to raise rates at the fastest pace of the institution’s modern era, and the past few weeks have started to bear out the consequences of that scramble.

Door No. 1: Recession
Last week’s run on Silicon Valley Bank — a midsize lender focused on venture capital-funded startups — has put financial markets and depositors on tenterhooks. The KBW Bank Index has lost a quarter of its value in the past seven trading sessions, and the ICE BofA MOVE Index, a measure of Treasury market volatility, is flirting with levels last seen after the collapse of Lehman Brothers. While SVB itself was far from Lehman, traders have understandably been asking themselves whether it was the tip of the iceberg. Indeed, a new bout of market panic engulfed traders on Wednesday as they warily considered the future of Credit Suisse Group AG.

Conceivably, some of this will blow over, and the Credit Suisse fallout will matter less in the US than it will to the European Central Bank. But behind all of these concerns is the fact that, historically speaking, the Fed rarely raises interest rates without triggering a recession. This time, it has lifted rates by a whopping 450 basis points in less than a year, and history suggests that the effects of that will start to be felt, roughly speaking, around now and play out in the year ahead.

How many other financial institutions have been caught flat-footed by the surge in interest rates? And where is the next crisis lurking? Could it be hiding in the commercial real estate market, as my colleague Robert Burgess underscored in a column this week? Or what about the opaque leveraged loan market, as Amelia Pollard, Giulia Morpurgo and Reshmi Basu asked recently.

Door No. 2: Inflation
Regrettably, these questions have surged to the fore when the Fed still doesn’t have sufficient evidence that the inflation problem itself has been solved. As the latest report showed Tuesday, the core consumer price index is still up 5.5% from a year earlier, which — according to Bloomberg Economics estimates — probably translates into about 4.7% on the core PCE, the Fed’s preferred gauge. With the fed funds target range currently at 4.5% to 4.75%, there’s still plenty of room to quibble over whether the policy rate looks sufficiently restrictive.

Still Too Low? | It's still not clear from recent data that Fed policy is sufficiently restrictive
Yet many investors are betting that the Fed’s tightening days are behind it and that policymakers will even start cutting by the summer.

There are several reasons that assessment will probably prove erroneous, short of emerging evidence of a full-blown banking crisis with systemic implications. First, doing so would invite comparisons to Arthur Burns, the 1970s Fed chair who famously gave up his fight on inflation too early, allowing it to fester. Such a move would recast all of Powell’s hawkish jawboning in recent months as “just an act” and risk undermining the Fed’s inflation-fighting credibility for years to come.

Second, history shows that the Fed rarely changes direction that quickly. If the Fed were to pause now and start cutting in July — as fed funds futures now imply — it would match the fastest about-face in the modern monetary policy era (which I count from 1994, when the central bank began announcing policy decisions publicly). Developed-market central banks tend to move to a given terminal rate and leave it there for a while to make sure it’s having its intended effect. Reversing course immediately is a de facto admission that they had the policy wrong all along, and it may fan market panic.

Where Are We? | As hiking cycles go, this one has been steep but not particularly long
In 2019, the rate plateaued and hovered at its peak for seven months; in 2006, it was 15 months; in 1999, it was eight. In the past 30 years, the fastest reversal came in 1995, when the Fed stayed at the peak for only five months. But even then, the cuts were surgical — just 75 basis points over seven months — rather than a race back to the bottom.

Much will depend on what happens to banks and markets in the next week before the Fed’s next decision on Wednesday. But for now, it still looks premature to conclude that the central bank is about to suspend its campaign of interest-rate increases, much less entertain cuts just a few months down the road.

Best-Case Scenario
There’s a decent chance, of course, that we will look back on March 2023 as a time of unfounded market histrionics rather than the start of a bona fide banking crisis. Indeed, market swings suggest that Fed policymakers may be looking at a vastly different set of circumstances when they meet: maybe much better, maybe worse. Either way, the volatility comes during continuing resilience in the US economy. Household balance sheets still look strong. Nobody’s uttering the words this week, but the soft-landing thesis is not dead yet, just less likely.

And frankly, it’s always been a bit pie in the sky. Investors should think of this as a dress rehearsal for what’s probably coming in the year ahead. Six to 12 months from now, the consumer economy will find itself in a much more vulnerable position as cash on hand dwindles and credit card balances grow, and the history of “long and variable” monetary policy lags suggests that more destabilizing events are probably in store for those increasing off-balance households and investors. If inflation vanishes between now and then, the Fed might just be able to come to the rescue and save face. Unfortunately, that’s far from the most likely scenario. For now, it just has to pick a door and hope for the best because poor decision-making in 2021 left it with no good choices.

Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company's Miami bureau chief. He is a CFA charterholder.