Joerg Bibow and Marketa Wolfe, Skidmore College

The Fed had two courses of action available when it came to setting rates. The first would have seen it continue aggressively raising rates, ignoring financial stability concerns – perhaps even seeing the hiking campaign as a sort of bloodletting that would squeeze inflation out of the economy. The second way forward would be to take a beat and see how the ongoing fragility in the banking sector plays out first.

Fortunately – in our view – the Fed did not choose the former.

While falling short of a total pause in raising interest rates – an option some market watchers had been calling for – the latest hike represents a substantial slowdown from the Fed’s previous plans, and therefore demonstrates the Fed’s caution in the face of a nascent banking situation.

It was able to do this in large part because there are clear signs inflation has come down.

As measured by the Personal Consumption Expenditure Price Index – the Fed’s preferred measure – inflation has declined from a 40-year high of 7% in June 2022 to 5.4% in January 2023.

And the main cause of the recent surge in inflation - COVID-19 supply chain disruptions – has eased. In addition, an upward wage-price spiral has not developed.

Furthermore, the banking turmoil might have already delivered an equivalent of another interest rate hike in terms of its impact on the economy.

Although inflation remains high by historical standards, the risk of its reaccelerating seems low. Altogether, this allowed the Fed to take a breath and deal with what’s going on in the banking sector.

Put another way, the Fed decided, with so much uncertainty about the impact the recent turmoil will have on the economy, the risk of causing more damage was greater than the risk of inflation.

This article is republished from The Conversation, an independent nonprofit news site dedicated to sharing ideas from academic experts. Like this article? Subscribe to our weekly newsletter.

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The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.