Iin his first Speaking as Federal Reserve Governor, Ben Bernanke offered a simple saying to explain a complex subject. The question was whether central banks should use monetary policy to tame frothy markets – for example, by raising interest rates to deflate housing bubbles. His response was that the Fed should “use the right tool for the job.” It should, he argued, rely on regulatory and lending powers in financial matters and conserve interest rates for economic goals such as price stability.
Two decades later, Mr. Bernanke’s doctrine faces a severe test in the reverse direction – as a framework for dealing with depleted, non-bubbly markets. On the one hand, the Fed is trying to quench the embers of a crisis that began with a run on the Silicon Valley bank (svb). On the other hand, officials are facing stubborn inflation after failing to get it under control over the past year. The tension between stabilizing the financial system, which requires central bank support, and containing price pressures, which requires tight policy, is extreme. But with two different tools, the Fed is attempting to do both. It’s an unlikely mission. And it’s one that other central banks will have little choice but to emulate in the coming months.
On March 22, at the end of a two-day meeting of the central bank’s rate-setting body, Fed Chair Jerome Powell laid out the logic of their sweeping support for the financial system undermine,” he said. However, he also claimed that the Fed could and would lower inflation. “Without price stability, the economy doesn’t work for anyone,” he said. The Fed put the policy into action, opting to raise interest rates by a quarter of a percentage point.
Before the meeting, there was a debate about whether officials would go through with their ninth straight rate hike. Continued tightening seemed a foregone conclusion as February’s numbers showed that inflation was still uncomfortably high and at 6% yoy, three times faster than the Fed’s target. But as panic spread, it followed svbcollapse of , some prominent voices called for a pause to study the impact on the economy. Or, as Eric Rosengren, a former president of the Fed’s Boston branch, put it, “After a major shock from an earthquake, should you go straight back to normal life?”
In the end, the Fed was undeterred. After already raising rates by nearly five percentage points last year – the sharpest tightening in four decades – the latest quarter-point hike was numerically staggering. But as a measure of Fed resolve, it mattered: it showed that Mr Powell and his colleagues believe they can use monetary policy tools, particularly interest rates, to fight inflation, even if tightening poses risks to financial stability .
The Fed is poised to adopt this stance as it can use a range of alternative tools to respond to market chaos. In recent weeks, the Fed has joined other parts of the state in trying to protect both assets and liabilities in the banking system. On the asset side, it has made it easier for troubled banks to access liquidity by offering to lend at the par value of government bonds, even when market prices are much lower. This has saved banks from having to take losses that totaled $620 billion at the end of 2022 – enough to wipe out almost a third of the equity in the American banking system.
As for liabilities, the Federal Deposit Insurance Corporation, a regulator, has pledged to stand behind large uninsured deposits svb and Signature, another bank that suffered a run. Treasury secretary Janet Yellen has hinted at similar support if depositors flee smaller banks, although on March 22 she said the Biden administration was not considering blanket insurance (which would require congressional approval). But even with deposit insurance, which by law is capped at $250,000, the message seems to be that accounts are safe regardless of size. The combination of Fed lending and insurance has helped calm things down for now: After a quarter-turn, the kbw Index of American bank stocks has stabilized somewhat.
The Fed’s nightmarish balancing act between inflation and financial stability looks very different from the past two crises. During both the global financial crisis of 2007-09 and the sudden economic shutdown of 2020 when Covid-19 struck, the Fed and other central banks threw in everything they had to revive the economy and prop up the financial system. Financial and economic risks pointed sharply down both times. That may have contributed to doubts about the Fed’s ability to go and chew gum — to fight inflation and ease market tensions.
For Fed watchers, however, such cross-cutting actions come as less of a surprise. In several instances — following the collapse of a major bank in 1984, a stock market crash in 1987, and a hedge fund explosion in 1998 — the Fed briefly stopped raising interest rates or cut them slightly, but shortly after did so again tightening policy. Economists at Citigroup, a bank, concluded that those experiences, not 2008 or 2020, are more relevant today. As markets are pricing in the possibility that the Fed could cut rates by half a percentage point later this year, Citi believes the central bank could surprise investors with its willingness to keep monetary policy tight as long as inflation remains high . In fact, it signaled just that. Along with the rate hike on March 22nd, the Fed released a summary of its forecasts. The median member of the Federal Open Market Committee thinks they will raise rates another quarter point this year and only start cutting them next year.
Nonetheless, in practice, the clean distinction between monetary policy and financial stability tools can appear more blurred. Take the Fed’s balance sheet. As part of an effort to tame inflation, the central bank began quantitative tightening last year by rolling a fixed number of maturing bonds off its balance sheet each month, draining liquidity from the banking system. Between May last year and early March, she shrank her fortune by around $600 billion. Then over the course of a few days after svb During the escape, its wealth grew by $300 billion — a by-product of the loans it made to banks through its discount window and other emergency operations. Currency lunatics see a clear difference: quantitative tightening is a permanent change to the Fed’s balance sheet, while emergency lending will disappear when things normalize. Given that one of the main channels through which balance sheet policy operates is a signal of the Fed’s intentions, the potential for confusion is evident.
Another blurred line is the feedback loop between financial stability and monetary policy. Most of those calling for a Fed pause weren’t crudely advocating the central bank having to bail out struggling investors. Rather, the more subtle point was that bank chaos and market turmoil were themselves tantamount to raising interest rates. Financial conditions – which include bond yields, credit spreads and equity values - have tightened in recent weeks. Torsten Slok of Apollo Global Management, a private equity firm, estimated that the shift in pricing represented an additional 1.5 percentage points of rate hikes by the Fed, enough to push the economy into a hard landing.
Not everyone agrees that the effect will be that big. Banks account for about a third of America’s lending, with capital markets and corporations like mortgage lenders providing the rest. This could protect companies from tighter lending standards at banks. Additionally, America’s largest banks make up more than half of the banking system by asset value, and they remain in strong shape. However, even with these caveats, the impact is still real. As banks shore up their balance sheets, both deposit and wholesale funding costs rise, transmitting the tightening to the financial system. Deutsche Bank estimates that if the credit shock is small, it will save half a percentage point annually bip Growth. The Fed will now probably have to go less far to tame inflation.
Ultimately, its ability to separate instability and inflation depends on the severity of the banking crisis. “When financial issues scream, they will always, and rightly so, trump slower-moving macroeconomic issues,” says Evercore’s Krishna Guha is, a consulting firm. The fact that America’s emergency interventions had gained traction over the past two weeks, with deposit outflows slowing and markets cutting losses, allowed the Fed to turn its attention back to inflation. It’s easy to imagine an alternative scenario where the interventions failed and she was forced to refrain from raising rates.
This explains the rush by the Swiss authorities to put an end to the Credit Suisse drama. Central bankers know only too well that the uncontrolled collapse of such a large corporation would send shockwaves through the global financial system. If so, they would have been under immense pressure to withdraw from the fight against inflation. The right tool for the right job is an attractive way to describe central bank goals. But it only works as long as the task of restoring stability after a financial explosion is done quickly. ■
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