The Fed’s Latest Interest Rate Hike Could Set Off a ‘Domino Effect’ in Regional Bank Failures

The Federal Reserve approved another quarter-point interest rate increase on Wednesday, marking the central bank’s tenth consecutive rate hike in its effort to curb persistent inflation despite recent troubles in the banking system.

The move raises the benchmark federal-funds rate to a range between 5% and 5.25%—the highest level since 2007—at a time when bank customers are already feeling anxious after a string of recent bank failures.

Fed Chair Jerome Powell said at a press conference that officials will watch to see whether future rate moves are necessary, hinting that Wednesday’s increase could be their last one for now depending on the extent of any lending pullback that follows last week’s collapse of First Republic Bank, the second-largest bank failure on record. “A decision on a pause was not made today,” Powell said. “We will be driven by incoming data meeting-by-meeting and we will approach that question at the June meeting.”

He also said that the U.S. banking system is “sound and resilient” and that the conditions in the banking sector have “broadly improved” since early March. “We’re committed to learning the right lessons from this episode,” he added.

Analysts say that the Fed’s decision to raise interest rates again has renewed concerns that some midsize or regional banks that have suffered large withdrawals of deposits could be on the edge of a precipice. “Each incremental interest rate hike beyond what they had anticipated is going to exacerbate the banking problem significantly,” says Brian Bethune, a financial economist and economics professor at Boston College. “Once that trust starts to erode, then you have a domino effect. And we’re on the brink right now of a major domino effect in the regional banks.”

Read More: Your Money Is Likely Safe, Even After Bank Failures. Here’s How to Be Sure

The banking system has been in turmoil since the collapse of Silicon Valley Bank and Signature Bank in early March, in part due to the Fed’s rapid interest rate increases over the past year. Many lenders are facing losses on older securities and loans, which pay relatively low interest rates compared with newer securities. First Republic, the third major U.S. bank to fail in the past two months, had been struggling for weeks and was sold to JPMorgan Chase in a deal announced early Monday morning. The fact that the Fed proceeded with a rate hike Wednesday despite serious market turbulence over the string of bank failures reveals the tricky spot Powell finds himself in: He needs to get inflation under control, without cratering midsize banks that are poorly positioned for a high-interest-rate environment.

“I have personally long felt that having small-, medium- and large-size banks is a great part of our banking system,” Powell said on Wednesday. “Regional banks serve very important purposes… I think it is healthy to have a range of different kinds of banking doing different things.”

Shares of U.S. regional banks PacWest Bancorp and Western Alliance Bank plunged on Tuesday as the demise of First Republic Bank triggered investor concerns about the financial health of other midsized lenders. But analysts don’t expect these banks and others to collapse à la First Republic, Silicon Valley, and Signature Bank. They say the previous bank collapses were all outliers and that the problems largely came down to mismanagement at the three banks, where large shares of customers had deposits that surpassed federal insurance limits and were more likely to move their money when it became clear the bank’s investment strategies were backfiring.

Smaller banks, Powell said on Wednesday, have been tightening lending standards since late last year as a result of the Fed’s ongoing interest rate hikes. “Some small and midsize banks have suffered large withdrawals of deposits due to a loss of consumer confidence… but in the case of banks who managed their assets along the lines of Silicon Valley Bank, they will be vulnerable and looking for ways to manage risk and be more conservative in their lending,” says Jim Granato, dean of the University of Houston’s School of Public Affairs, who researches monetary policy.

To some degree, the Fed wants that scenario to play out, because less borrowing and spending could help ease inflation. But the banking challenges have put the Fed in an increasingly difficult position. Service price increases have shown little sign of slowing, sparking concerns among analysts that the Fed won’t be able to claw back price increases to their goal.

“The reality is that there’s a mounting level of stress on most midsize or small banks, which is almost intolerable because they don’t have the same tools as the big Wall Street banks to hedge their risk exposure,” Bethune says. For example, smaller banks do not have access to certain types of derivatives or trading desks that can hedge against interest rate risks. Instead, they do interest rate management by matching the maturity of their deposits with the maturity of their short-term assets—but that can be arduous as customers lose confidence and withdraw their money.

Read More: 7 Ways to Manage Financial Stress

It remains unclear if policymakers believe the economy and inflation are resilient enough that they will need to adjust borrowing costs more to cool things down, as Powell opted to leave the Fed’s options open instead of declaring a timeline for pausing the rate increases. But pressure is mounting on the Fed to make a decision.

A group of senior House and Senate Democrats on Monday called on Powell to pause interest rate hikes due to the potential economic fallout. “While we do not question the Fed’s policy independence, we believe that continuing to raise interest rates would be an abandonment of the Fed’s dual mandate to achieve both maximum employment and price stability and show little regard for the small businesses and working families that will get caught in the wreckage,” the lawmakers wrote in a letter to Powell.

Granato says it could make sense for the Fed to pause interest rate hikes now that the federal funds rate and inflation rate are both around 5%. “A useful rule of thumb is for the federal funds rate target to be at a level that is roughly in line with the current inflation rate,” he says. “The Fed is indeed trying to balance bringing inflation expectations down to something like 2%, but as we are seeing, the possibility of a recession and stress to the banking system is increasing.”

But Fed policymakers have been adamant that they do not expect to lower rates imminently, and more increases could be warranted. “I think a particular focus for us going forward—now over the past six, seven weeks—is going to be what’s happening with credit tightening or small- and medium-sized banks tightening credit standards,” Powell said. “And is that having an effect on loans [and] lending so we can begin to assess how that fits in with monetary policy?”