The Silicon Valley Bank debacle suddenly changed the outlook for interest rates in 2023

Financial turmoil and cooling inflation could mean the Fed slows or even holds off its interest rate hikes at its meeting next week.

• Investors expected the Fed to raise rates March 21-22. The question was just how much.
• Silicon Valley Bank crashed, so now investors are betting the Fed will slow its roll. 
• The Fed has to cool inflation without further disrupting the financial system.

The weekend threw banks and financial markets into chaos and made the Federal Reserve's job a whole lot harder.

In a chaotic series of events last week, regulators shut down Silicon Valley Bank (SVB) on Friday — and just two days later, they announced they would be bailing out SVB depositors. The move was controversial, meeting criticism from both Democratic and Republican lawmakers.

It also shook up expectations for the Federal Reserve's next move to curb the country's inflation problem.

The Fed has increased interest rates eight times over the last year to keep prices from rising too quickly, and since December, it has slowed the pace of hikes as it works to achieve its goal of getting inflation to its 2% goal. 

The central bank has made clear that interest rate cuts will not happen this year, and Fed Chair Jerome Powell has repeatedly stated that raising borrowing costs will be necessary this year as the central bank continues to fight inflation.

The pace and duration of those interest rate hikes is at the top of mind for markets and investors. Last Friday, investors thought there was a 0% chance the Fed would keep rates where they targeted them at 450-475 basis points in February, according to the CME FedWatch Tool, whose predictions are based on investors hedging against upcoming rate hikes.

Before SVB's collapse, investors were betting there was nearly a 60% probability the Fed would raise rates another 25 basis points and a 40% chance the Fed would bring them up 50 points at the next Federal Open Market Committee meeting scheduled for March 21 and 22. Though inflation cooled in February, with the latest CPI showing 6% inflation compared to this time last year, it's still higher than the 2% desired, so investors expected the Fed to raise rates.

The collapse of SVB on Friday reversed predictions of such a hawkish Fed. After vacillating much of Monday, investors seem to have settled their bets: There will be a 28.4% chance the Fed will hold rates steady, while giving a 25 basis point hike a 71.6% probability, as of 1:58 PM EST Tuesday afternoon. Investors now think a larger 50 point hike is out of the question.

Investors expect the Fed to back off its aggressive rate hikes because these indirectly caused SVB's collapse. The Fed's rate hikes made borrowing more expensive, killing the bank's primary business from venture capitalists investing in tech startups, forcing their selloff of government bonds at a loss of $1.8 billion, and leading depositors to make a run on the bank when they feared their money was no longer safe. The Federal Deposit Insurance Corporation took control of SVB on Friday and continues to look for buyers.

Meanwhile, Goldman Sachs thinks the Fed won't raise rates at all as more banks are already expected to fail. Another jolt could put more banks in the red zone. 

The Fed will announce its next interest rate decision next week, and it's likely Powell will be asked to address SVB's fallout during the press conference — especially after facing criticism from Democratic lawmakers like Sen. Elizabeth Warren, who on Tuesday called for him to recuse himself from the Fed's internal review of SVB because she said his "actions to allow big banks like Silicon Valley Bank to boost their profits by loading up on risk directly contributed to these bank failures."

All of this is to say the Fed can no longer just worry about inflation. One way or another, banks and investors are telling us the Fed has to worry about the stability of the financial system too, making hefty rate hikes less likely, at least for now.