Markets Expect the Fed to Raise Rates Despite Banking Turmoil

Banks in focus as the Fed weighs its rates move

If market predictions are correct, the Fed on Wednesday will raise borrowing costs by a quarter of a percentage point, even as growing turmoil in the stocks of regional banks threatens to choke off credit to businesses and consumers, pushing the economy into recession.

The decision comes amid a brutal sell-off in regional banks’ shares,which has wiped billions off smaller lenders’ market valuations. Investors have been worried about the health of these banks since March, when Silicon Valley Bank collapsed in one of the most prominent bank failures in U.S. history.

Regulators had hoped that the sale of the embattled First Republic Bank to JPMorgan Chase this week would contain the panic. But short sellers, investors who profit off bets that stock prices will fall, have continued to take aim at regional lenders like PacWest, Western Alliance and Zions Bancorp. (Shares in PacWest and Western Alliance are down again in premarket trading.)

The market carnage could result in more pain for regional banks.Falling prices may cause C.F.O.s to say, “‘You know what, maybe I should think about diversification and moving my funding’” out of these lenders, Ryan Nash, a research director at Goldman Sachs, said in a webinar on Tuesday.

He added that while “most of the large failures are likely behind us, I do think there is a risk that pressure on stock prices could reinvigorate” worries about the sector’s health.

Meanwhile, the Fed faces political pressure. Ten progressive lawmakers, including Senators Elizabeth Warren and Bernie Sanders, urged the central bank to pause its rate hikes to “avoid engineering a recession that destroys jobs and crushes small businesses.”

The lawmakers cautioned Jay Powell, the Fed chair, that raising borrowing prices could further compound trouble for beleaguered banks.

None of this is likely to deter the Fed from raising rates on Wednesday, analysts said. Indeed, a “shock pause” would “do more harm than good” by spooking an already jittery market, according to Elsa Lignos, the global head of FX strategy at RBC Capital Markets.

But economists increasingly believe that Wednesday’s increase will be the last in this tightening cycle. Watch what Mr. Powell says about upcoming Fed meetings: If he suggests that the central bank needs to remain hawkish on rates to fight inflation, that could send stocks — especially those of regional banks — especially hard.

Ms. Lignos advised paying attention to what Mr. Powell says about whether “additional policy firming may be appropriate,” a line of guidance he used after the March meeting: If that wording is softened or deleted altogether, she said, it may indicate a dovish turn by the Fed.