The banking industry is in panic and the Federal Reserve is in a dilemma: Can it still raise interest rates in March?

In just one week, the market's "script" has changed dramatically. It has been nearly a year since the Federal Reserve began raising interest rates to combat high inflation. Investors have been focusing on when the central bank might end its rate hikes over the past year. Initially, few investors included bank failures on their list of potential market risks in 2023.

On March 13, the KBW Bank Index in the United States fell by about 11%, and the SPDR Regional Bank ETF fell by more than 12%, both of which set the largest single-day declines in the past two years. Among them, First Republic Bank (FRC) fell by more than 80% at one point, and Western Alliance Bancorp fell by about 75%, and encountered multiple circuit breakers; PacWest Bancorp fell by more than 48%, and Charles Schwab also fell by more than 20% at one point. Credit Suisse's stock price once plummeted by more than 30% during trading on Thursday, reaching 1.55 Swiss francs per share, setting a record low and exacerbating market panic. Previously, starting with the bankruptcy of Silicon Valley Bank, three banks in the United States went bankrupt in a week, setting off an unprecedented panic in the banking industry.

Now, with Silicon Valley Bank’s collapse and the resulting market turmoil, the dynamic has changed. The Federal Reserve will weigh the risks to financial stability and persistent inflation at its policy meeting next week. For investors, both concerns are suddenly top of mind.

Zach Hill, a portfolio manager at Horizon Investments, which manages nearly $7.3 billion in assets, told The Wall Street Journal that in recent months "inflation control has really been the Fed's sole objective, and now we've introduced the concept of financial instability. It's not very clear how the Fed balances that."

Last week, investors were debating whether the Fed would raise interest rates by 25 basis points, as officials did in February, or by 50 basis points, as they did in December. Now, the bigger question for investors is whether the Fed will raise rates next week.

The S&P 500 is up 0.4% in 2023, giving up nearly all of its gains for the year after a string of stronger-than-expected economic data. Government bond yields plunged after rising for much of the year, reflecting a sudden rush to safety.

Inflation remains hot. The Labor Department said Tuesday that its consumer price index was 6% higher in February than a year ago. While price pressures have cooled for eight straight months, inflation remains well above the Fed’s 2% target. Last week’s jobs report told a similar story: The U.S. added 311,000 jobs in February, beating economists’ expectations but down sharply from the 517,000 jobs added in January.

“The situation has become very different recently, and now we really need to discuss things that could have adverse effects on the economy, the markets and our portfolios,” Sam Stovall, chief investment strategist at CFRA, told The Wall Street Journal.

The market turmoil began last Thursday when shares of SVB Financial Group, the parent of Silicon Valley Bank, plunged 60% amid a run on deposits. The stock did not open for trading on Friday, the morning the bank was seized by the Federal Deposit Insurance Corporation and is now exploring various options for selling its assets.

Two of the largest banks serving cryptocurrency companies , Silvergate Capital Corp. and Signature Bank, have also collapsed in recent days.

Regional bank stock prices plunged but rebounded after government officials took steps to limit the impact. On Tuesday, Moody's Investors Service cut its outlook for the U.S. banking system, citing a "rapidly deteriorating operating environment." The ratings firm put six U.S. banks' credit ratings under review for possible downgrades.

Credit Suisse's stock and bond prices plunged on Wednesday after European regulators contacted the Swiss bank about its financial exposure to troubled Silicon Valley Bank.

Moody's said further rate hikes could worsen banks' problems. Futures traders see an even chance of another quarter-point rate hike next week or no rate hike.

Investors remain wary of signs of contagion, with strategists at JPMorgan Chase & Co. warning on Monday that losses in the bond market could weigh on other asset classes such as commercial real estate, private equity and venture capital.

“When the economy slows and funding costs rise, all those implicit or explicit carry trades are forced to unwind, causing the cycle to end,” the futures trader said.

Investors’ search for safety led to frenzied trading: As of Monday, the yield on the two-year Treasury note had its biggest three-day drop since 1987. Longer-dated yields also fell sharply. When bond prices rise, bond yields fall.

The rally in Treasury bonds comes after short-term bond yields rose steadily over the previous month.

Thomas Martin, a portfolio manager at Globalt Investments, told The Wall Street Journal that the sudden change in market sentiment was like "all of a sudden, you get slapped in the face."

Liquidity in the 10-year Treasury futures market is now less than half of what it was before the collapse of Silicon Valley Bank, according to Quantitative Brokers. Reduced liquidity means a particular trade could have a bigger impact on market prices.

The chaos spread beyond the bond market. The S&P 500 fell 4.5% last week, its worst week this year. After a brief respite, the index plunged again on Wednesday, falling 1.7% in early trading.

The KBW Bank Index has fallen 22% in the past week. On Monday, Wall Street's fear gauge, the Cboe Volatility Index, hit its highest level in months. Put option trading volume on all stocks and exchange-traded funds hit a record high on Friday, according to Cboe Global Markets. And the price of Bitcoin soared.

Investors worry that a credit crunch could discourage regional banks from lending to individuals and businesses, which could cause the economy to contract. The Russell 2000 index of smaller companies fell 7.8% in the past week.

The shock has investors awaiting signals on how it affects the Fed’s longer-term plans and reassessing the contents of their portfolios.

“We are taking a hard look at the assets we own and looking for opportunities as well as possible problems,” Mr. Hill told The Wall Street Journal.

Some investors and strategists remain bullish on the market, assuming the credit crisis subsides soon and the Federal Reserve eventually decides to pause its rate hikes.

Mr. Stovall of CFRA told The Wall Street Journal that his year-end price target for the S&P 500 is 4,360, about 10% above current levels.