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Worst banking turmoil since 2008 means the Federal Reserve is damned if it does and damned if it doesn’t participate in interest rate decisions


The Federal Reserve stands for one crucial decision on March 22, 2023: or continue his aggressive fight against inflation or stop it.

Another big rate hike would exacerbate the risk global banking turmoil fueled by the bankruptcy of Silicon Valley Bank on March 10. A rate hike that is too low or not at all, as some argue, could not only lead to a resurgence of inflation, but could also cause investors to worry that the Fed thinks the situation is even. worse than they thought – leading to more panic.

What should a central banker do?

As a financial scholar, I have studied the close connection between Fed policy and financial markets. Let me just say that I wouldn’t want to be a Fed policymaker right now.

Break it, you bought it

When the Fed starts raising rates, it usually keeps it up until something breaks.

The US Federal Reserve began its rate hike campaign early last year as inflation started to pick up. After initially erroneously calling inflation “transient,” the Fed shifted into high gear raised rates eight times from just 0.25% in early 2022 to 4.75% in February 2023. This is the fastest pace of rate hikes since the early 1980s – and the Fed is not done yet.

Consumer prices increased by 6% in February compared to a year earlier. While that’s below a peak of 9% annualized in June 2022, it’s still significantly above the Fed’s inflation target of 2%.

But then something broke. Seemingly out of nowhere, Silicon Valley Bank, followed by Signature Bank, collapsed virtually overnight. Together they had more than $300 billion in assets and became the second and third largest banks go bankrupt in US history.

Panic quickly spread to other regional lenders, such as First Republic, and confused markets globally, raising the prospect of even larger and more widespread bank failures. Even one $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 raises rates more than markets expect – currently a 0.25 percentage point increase – it could lead to further concerns. My research shows that interest rate changes have a much greater effect on the stock market in bear markets – when there is a prolonged fall in share prices, such as the US is experiencing now – than in good times.

Making the SVB problem worse

In addition, the Fed could make the problem that led to Silicon Valley Bank’s problems worse for other banks. That’s because the Fed is at least indirectly responsible for what happened.

Banks finance themselves mainly by taking deposits. They then use those essentially short-term deposits to make loans or make investments for longer terms at higher rates. But investing short-term deposits in longer-maturity securities — even ultra-secure U.S. Treasury bonds — creates what is known as interest risk.

That is, when interest rates rise, as they did throughout 2022, the values ​​of existing bonds fall. SVB was forced Sell ​​$21 billion in securities that lost value due to the Fed’s rate hikes with a loss of $1.8 billion, triggering the crisis. When the savers of the SVB got wind of it and attempted to withdraw $42 billion on March 9 alone – a classic bank run – it was over. The bank simply could not meet the requirements.

But the entire banking industry is sitting with hundreds of billions of dollars in unrealized losses – $620 billion as of December 31, 2022. And if interest rates continue to rise, the value of these bonds will continue to fall, fundamentally weakening the financial situation of banks.

The Fed has been aggressively raising rates to counter the rapid rise in food prices, among other things.
AP Photo/Wilfredo Lee

Risks of slowing down

While that might suggest that it’s a good idea to get hold of the rate hikes, it’s not that simple.

Inflation has been a major problem plaguing the US economy since 2021 as prices for homes, cars, food, energy and much more skyrocket for consumers. The last time consumer prices rose that much, in the early 1980s, the Fed had to raise interest rates so high that it pushed the US economy into recession – twice.

High inflation quickly cuts into how many things your money can buy. It also makes it more difficult to save money because it eats into the value of your savings. When high inflation lasts for a long time, it becomes entrenched in expectations, making it very difficult to control.

This is why the Fed raised rates so quickly. And it’s unlikely to have done enough to cut rates to the 2% target, so a pause in rate hikes would mean inflation can stay high for longer.

In addition, the retreat from the year-old inflation campaign could send the wrong signal to investors. If central bankers show that they are really concerned about a possible banking crisis, the market may think that the Fed knows that the financial system is in serious trouble and that things are worse than previously thought.

So what should a Fed do

The complex global financial system shows at least some cracks.

Three US banks collapsed in a matter of days. Credit Suisse, a 166-year-old legendary Swiss lender, teetered on the edge until the government organized a bargain to match USB. A $30 billion bailout from regional US lender First Republic was unable to stop the fall in its shares. are American banks applying for loans from the Fed as if it were 2008, when the financial system almost collapsed. And liquidity in the treasury market – basically the blood that keeps the financial markets pumping – is drying up.

Before the collapse of Silicon Valley Bank, interest rate futures were setting the odds of a rate hike – either 0.25 or 0.5 percentage points – on March 22 at 100%. The probability that there would be no increase at all rose to 45% on March 15, before falling to 14% on March 21, with a balance increase of 0.25 percentage points.

Raising rates at a time like this would mean putting more pressure on a structure that is already under great strain. And if things take a turn for the worse, the Fed would likely have to make a quick U-turn, which would seriously damage the Fed’s credibility and ability to do its job.

Fed officials are rightly concerned about fighting inflation, but they also don’t want to light the fuse of a financial crisis, which could plunge the US into recession. And I doubt it would be a mild one like the friendly economists are concerned could trigger the Fed’s inflation battle. Recessions caused by financial crises tend to be deep and long – putting many millions out of work.

What would normally be a routine Fed meeting becomes a high-wire balancing act.

The author of what'snew2day.com is dedicated to keeping you up-to-date on the latest news and information.

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