By Alexander Kurov*
The Federal Reserve faces a pivotal decision on March 22: whether to continue its aggressive fight against inflation or put it on hold.
Making another big interest rate hike would risk exacerbating the global banking turmoil sparked by Silicon Valley Bank’s failure on March 10. Raising rates too little, or not at all as some are calling for, could not only lead to a resurgence in inflation, but it could cause investors to worry that the Fed believes the situation is even worse than they thought – resulting in more panic.
What’s a central banker to do?
As a finance scholar, I have studied the close link between Fed policy and financial markets. Let me just say I would not want to be a Fed policymaker right now.
Break it, you bought it
When the Fed starts hiking rates, it typically keeps at it until something breaks.
The U.S. central bank began its rate-hiking campaign early last year as inflation began to surge. After initially mistakenly calling inflation “transitory,” the Fed kicked into high gear and raised rates eight times from just 0.25% in early 2022 to 4.75% in February 2023. This is the fastest pace of rate increases since the early 1980s – and the Fed is not done yet.
Consumer prices were up 6% in February from a year earlier. While that’s down from a peak annual rate of 9% in June 2022, it’s still significantly above the Fed’s 2% inflation target.
But then something broke. Seemingly out of nowhere, Silicon Valley Bank, followed by Signature Bank, collapsed virtually overnight. They had over US$300 billion in assets between them and became the second- and third-largest banks to fail in U.S. history.
Panic quickly spread to other regional lenders, such as First Republic, and upset markets globally, raising the prospect of even bigger and more widespread bank failures. Even a $30 billion rescue of First Republic by its much larger peers, including JPMorgan Chase and Bank of America, failed to stem the growing unease.
If the Fed lifts interest rates more than markets expect – currently a 0.25 percentage point increase – it could prompt further anxiety. My research shows that interest rate changes have a much bigger effect on the stock market in bear markets – when there’s a prolonged decline in stock prices, as the U.S. is experiencing now – than in good times.
Making the SVB problem worse
What’s more, the Fed could make the problem that led to Silicon Valley Bank’s troubles even worse for other banks. That’s because the Fed is at least indirectly responsible for what happened.
Banks finance themselves mainly by taking in deposits. They then use those essentially short-term deposits to lend or make investments for longer terms at higher rates. But investing short-term deposits in longer-term securities – even ultra-safe U.S. Treasuries – creates what is known as interest rate risk.
That is, when interest rates go up, as they did throughout 2022, the values of existing bonds drop. SVB was forced to sell $21 billion worth of securities that lost value because of the Fed’s rate hikes at a loss of $1.8 billion, sparking its crisis. When SVB’s depositors got the wind of it and tried to withdraw $42 billion on March 9 alone – a classic bank run – it was over. The bank simply couldn’t meet the demands.
But the entire banking sector is sitting on hundreds of billions of dollars’ worth of unrealized losses – $620 billion as of Dec. 31, 2022. And if rates continue to go up, the value of these bonds will keep going down, which fundamentally weakens banks’ financial situation.
Risks of slowing down
While that may suggest it’s a no-brainer to put the rate hikes on hold, it’s not so simple.
Inflation has been a major problem plaguing the U.S. economy since 2021 as prices for homes, cars, food, energy and so much else jump for consumers. The last time consumer prices soared this much, in the early 1980s, the Fed had to raise rates so high that it sent the U.S. economy into recession – twice.
High inflation quickly cuts into how much stuff your money can buy. It also makes saving money more difficult because it eats at the value of your savings. When high inflation sticks around for a long time, it gets entrenched in expectations, making it very hard to control.
This is why the Fed jacked up rates so fast. And it’s unlikely it’s done enough to bring rates down to its 2% target, so a pause in lifting rates would mean inflation may stay higher for longer.
Moreover, stepping back from its one-year-old inflation campaign may send the wrong signal to investors. If central bankers show they are really concerned about a possible banking crisis, the market may think the Fed knows the financial system is in serious trouble and things are more dire than previously thought.
So what’s a Fed to do?
At the very least, the complex global financial system is showing some cracks.
Three U.S. banks collapsed in a matter of days. Credit Suisse, a 166-year-old storied Swiss lender, was teetering on the edge until the government orchestrated a bargain sale to rival USB. A $30 billion rescue of regional U.S. lender First Republic was unable to arrest the drop in its shares. U.S. banks are requesting loans from the Fed like it’s 2008, when the financial system all but collapsed. And liquidity in the Treasury market – basically the blood that keeps financial markets pumping – is drying up.
Before Silicon Valley Bank’s collapse, interest rate futures were putting the odds of an increase in rates – either 0.25 or 0.5 percentage point – on March 22 at 100%. The odds of no increase at all have shot up to as high as 45% on March 15 before falling to 30% early on March 20, with the balance of probability on a 0.25 percentage point hike.
Increasing rates at a moment like this would mean putting more pressure on a structure that’s already under a lot of stress. And if things take a turn for the worse, the Fed would likely have to do a quick U-turn, which would seriously damage the Fed’s credibility and ability to do its job.
Fed officials are right to worry about fighting inflation, but they also don’t want to light the fuse of a financial crisis, which could send the U.S. into a recession. And I doubt it would be a mild one, like the kind economists have been worried the Fed’s inflation fight could cause. Recessions sparked by financial crises tend to be deep and long – putting many millions out of work.
What would normally be a routine Fed meeting is shaping up to be a high-wire balancing act.
*Alexander Kurov, Professor of Finance and Fred T. Tattersall Research Chair in Finance, West Virginia University. This article is republished from The Conversation under a Creative Commons license. Read the original article.
34 Comments
Its not quite that simple is it? The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Plunging the US into recession goes against the maximum employment part of their mandate.
What a hyperbole!
People wanting to throw the baby out with the bath water and screaming 3rd world & Zimbabwe because we have 7% of inflation is just ridiculous!!
Yes, inflation is hurting everybody and we need to get on top of it but looking at most fundamentals like prices for oil, gas, coal, metals & other natural resources it's pretty clear that inflation has mostly been stopped in the tracks.
What we're currently seeing is a ripple effect from past price shocks, first in fundamentals, then in products and finally in wages catching up.
We also have to consider that most rate hikes take months to become effective so we haven't yet seen any effects of the tigthening in the last 6 months.
So stop the hysteria, get a cup of tea and calm down!
7% inflation is significant. And hurting a lot of people. The reason people are likely frustrated and using forums to vent - is that the reserve banks created a lot of the issues by holding rates too low too long and creating too much money - and then misreading the resulting inflation as temporary. So now there is little faith they will act correctly and may pause - and miss their chance to break wage increase cycles and potentially rekindle spending habits bourne of the boom.... its the local impact that is the issue.
Its doubly important due to the reasons for the imported inflation.. being largely to do with Russia and China. Who may yet throw more fuel on the fire.
Once Orr can point to lowering inflation and show a few quarters of falls - back into his target band. then people will probably chill out.... he is harly on target yet
But the entire banking sector is sitting on hundreds of billions of dollars’ worth of unrealized losses – $620 billion as of Dec. 31, 2022
Gulp...
When the heck are we finally going to let companies (including banks) fail? It's what should have happened in 2008, and everything will just get worse until we finally accept that a good recession is a natural, and presently very needed, part of the economic cycle.
The issue is who offers the insurance. It doesnt look like insurance to me. If it was then the insurer would be far stricter with the banks on their practices or the premiums wouldnt be affordable.
The deposit guarantee scheme is another con paid for by the banks customers but ulimately would be backed up by the taxpayer.
No the financial sector comes to a halt. The productive part of society (blue collar) will be just fine. Business as usual, crops to be harvested, widgets to be made and sold. The FIRE sector comes to a halt, but society does not need them to survive. Sure need us farmers.
The Irish didn't need banks and it all worked quite well thank you very much.
https://www.independent.co.uk/voices/comment/we-can-all-get-by-quite-we…
Undated cheques, often endorsed over to others but never cashed, became a form of currency. When the supply of cheques dried up, people wrote new ones on any available piece of paper, sometimes adding a postage stamp to give it an official appearance. There was talk of some cheques being written on beer mats and lavatory paper. It was a system that worked because it drew on local knowledge and trust. The people exchanging cheques and IOUs knew each other well, and if they did not, they could soon find the necessary information to assess each other’s credit-worthiness.
Hmm, seems like this was in an entirely different world. Cant imagine it working now, the local countdown supermarket owner doesn't know me from a bar of soap, he isn't going to extend credit to me, and cheques are a relic of the past.
I think you vastly under estimate how much of an effect the FIRE sector coming to a shuddering crawl would have. How many marbled angus/wagyu steaks get sold when no RE agent is celebrating another big sale? Nor is the mortgage broker or the banker, and the Audi salesman is also out a job, so there goes one more customer from the Barber/Hairdressers regulars. And so on down the chain till everybody in any sort of job exposed to discretionary spending is tightening up on the purse strings.
If The Fed raises interest rates, and it's the wrong thing to do, they can drop them at any time they chose.
If they don't raise rates and Inflation gets away, nothing they can do will reign it in expect much higher interest rates, regardless of what they might want to do.
Given those two possibilities, it appears obvious to me what should be done. But we'll all soon know.
Highly recommend reading Arthur Hayes most recent blog.
https://blog.bitmex.com/kaiseki/
I'll copy this out verbatim.
"The Fed and US Treasury did not let a good crisis go to waste. They devised a truly elegant solution to solve a number of systemic issues. And the best part is, they get to blame mismanaged crypto- and tech-focused banks as the reason they had to step in and do something they would’ve had to do anyway.
Now, I will walk through the truly game-changing document that describes the BTFP. (Quotes from the document are in bold and italics, and below each is a breakdown of their practical implications.)
Bank Term Funding Program
Program: To provide liquidity to U.S. depository institutions, each Federal Reserve Bank would make advances to eligible borrowers, taking as collateral certain types of securities.
Borrower Eligibility: Any U.S. federally insured depository institution (including a bank, savings association, or credit union) or U.S. branch or agency of a foreign bank that is eligible for primary credit (see 12 CFR 201.4(a)) is eligible to borrow under the Program.
This is pretty self explanatory – you need to be a US bank to partake in the program.
Eligible Collateral: Eligible collateral includes any collateral eligible for purchase by the Federal Reserve Banks in open market operations (see 12 CFR 201.108(b)), provided that such collateral was owned by the borrower as of March 12, 2023.
This means that the financial instruments eligible for use as collateral under the program are largely limited to US Treasury debt and Mortgage Backed Securities. By setting a cutoff date, the Fed has limited the scope of the program to the total size of UST and MBS held by US banks (approximately $4.4 trillion).
Advance Size: Advances will be limited to the value of eligible collateral pledged by the eligible borrower.
There are no size limitations. If your bank holds $100 billion of UST and MBS, you can submit that total amount to be funded using the BTFP. This means that the Fed could in theory lend against the entire stock of UST and MBS securities held on US banking balance sheets.
The previous two BTFP paragraphs are so important to understand. The Fed just conducted $4.4 trillion of quantitative easing under another guise. Let me explain.
QE is the process whereby the Fed credits banks with reserves, and in return banks sell the Fed their UST and MBS holdings. Under the BTFP, instead of buying the bonds directly from the banks, the Fed will print money and lend it against the banks’ pledges of UST and MBS collateral. If depositors wanted $4.4 trillion in cash, the banks would just pledge their entire UST and MBS portfolio to the Fed in return for cash, which it then passes to depositors. Whether it’s QE or BTFP, the amount of money created by the Fed and put into circulation grows.
Rate: The rate for term advances will be the one-year overnight index swap rate plus 10 basis points; the rate will be fixed for the term of the advance on the day the advance is made.
Collateral Valuation: The collateral valuation will be par value. Margin will be 100% of par value.
The Fed’s money is priced at the 1-year interest rate. Given that short term rates are well above long-term rates, this means banks, for the most part, accrue negative interest over the life of the loan. Even though losses are bad, they get to exchange underwater bonds for 100% of their value, rather than recognising losses and going bankrupt. Err’body keeps their job, except for the poor sods at Silvergate, SVB, and Signature. The first shall be the last …
Advance Term: Advances will be made available to eligible borrowers for a term of up to one year.
Program Duration: Advances can be requested under the Program until at least March 11, 2024.
The program is stated to only last one year …when has a government ever given back the power that the people gave them during a time of crisis? This program will almost certainly be extended preemptively – otherwise, the market will throw a big enough fit to demonstrate it needs its fix of printed money, and the program will be extended regardless."
TL:DR. expect hyperinflation of assets from all the money that was just printed. It is likely to be Yield Curve Control in effect.
Brilliant - thanks for the summary. Basically sounds like they've prevented losses to depositors from long overdue recognition of the devaluation of bonds at the price of pumping up money supply (inflation). Central banks really only have this one trick, but it get's some really fancy names.
At least it's only QE of up to 4.4T at this stage. That is about 2 year's worth of QE during COVID so nothing special.
America’s banks are missing hundreds of billions of dollars | The Economist
Federal Reserve’s reverse-repo facility: "...use of the facility has jumped in recent years, owing to vast quantitative easing (qe) during covid-19 and regulatory tweaks which left banks laden with cash. qe creates deposits: when the Fed buys a bond from an investment fund, a bank must intermediate the transaction. The fund’s bank account swells; so does the bank’s reserve account at the Fed. From the start of qe in 2020 to its end two years later, deposits in commercial banks rose by $4.5trn, roughly equal to the growth in the Fed’s own balance-sheet."
By accident, crisis or intention, Banks everywhere have become wards of State. They can't be allowed to collapse and take down the system of exchange and value storage. Some small banks may be sacrificed or merged with bigger banks, leading to more consolidation and more TBTF Banks. The monetary policy of controlling inflation has ceased to work long ago, after a few crises. The current inflation is also due to supply issues, wars, political instability, super power rivalry, etc. These cannot be wished away with raising the rates.
Engineering Recession has already shown to have the unintended consequence of bank failure.
Central Banks' Playbook has become obsolete.
As long as the Politicians in the Government are ignorant of how the financial systems work, the Central Banks will hold sway and try to screw it all up.
Good luck to us.
Fantastic visual of the Fed funds futures this year. Quite the swing!
https://twitter.com/DylanLeClair_/status/1638206877740744705?s=20
We welcome your comments below. If you are not already registered, please register to comment.
Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.