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Faculty Viewpoints

The Fed Pushed Silicon Valley Bank Off the Cliff

Rising interest rates helped prompt a run on Silicon Valley Bank last week. Yale SOM’s Jeffrey Sonnenfeld and Steven Tian and Jeremy Siegel of the Wharton School write that the Federal Reserve’s impatience in taming inflation could tip the economy into crisis.

Customers outside the  headquarters of the Silicon Valley Bank on March 13.

Customers outside the headquarters of the Silicon Valley Bank on March 13.

Noah Berger/AFP via Getty Images
  • Jeremy Siegel
    Russell E. Palmer Professor Emeritus of Finance, Wharton School of the University of Pennsylvania
  • Jeffrey A. Sonnenfeld
    Senior Associate Dean for Leadership Studies & Lester Crown Professor in the Practice of Management
  • Steven Tian
    Director of Research, Chief Executive Leadership Institute

This commentary originally appeared in Fortune.

Thanks to President Joe Biden and Secretary Janet Yellen’s strong leadership of a joint Treasury, FDIC, and Fed response to stem the tide of further contagion from Friday’s collapse of Silicon Valley Bank, bold emergency measures are helping ensure that all deposits are safe and secure without bailing out risk-taking executives and investors—while saving at least 60,000 innocent businesses and an estimated 10 million workers, in addition to backstopping other regional banks to lessen the risk of any spillover bank runs. This stops the domino effect of knocking over other banks before it even gets started.

The most common line after a catastrophe is “now is not the time for the blame game!” In fact, even President Dwight Eisenhower advised that “the search for a scapegoat is the easiest of all hunting expeditions.”

However, unless we realize what went wrong, we cannot repair the problem moving forward. No ER doctor would ever say to a bleeding patient, “now is not the time to diagnose what happened!”

Even after Silicon Valley Bank’s collapse, some economists are still calling for a 50 basis point rate hike. Such calls are reckless and further rate hikes would increase the risk of more Silicon Valley Bank-type implosions.

Sure, there were some missteps by Silicon Valley Bank executives—they thought they were making the most prudent investments in U.S. Treasuries, the gold standard of risk-free investments, only to see Treasuries prices plummet with rising rates. More perplexingly, they ostensibly had 3% more capital reserves than required yet they were still needlessly alarmist in announcing additional capital raises, sparking a fear-driven stampede through their own ham-handed execution. But they only pulled the fire alarm because somebody lit a match. Who was it that lit that match?

Make no mistake about one of the prime reasons for SVB’s implosion: Fed shrapnel killed this bank and may send the economy into recession in the process.

We have been warning for months that the Fed is oversteering the economy, but this crisis is more evidence that the Fed has gone too far and might steer the economy not just off the highway but right off a cliff.

Amazingly, even after Silicon Valley Bank’s collapse, some economists are still calling for a 50 basis point rate hike at the FOMC meeting later this month with peak rate forecasts surpassing 6%. Such calls are reckless and further rate hikes would increase the risk of more Silicon Valley Bank-type implosions.

As we’ve been arguing, the Fed has it all wrong and is stubbornly targeting the wrong problem using the wrong tool. The decline in the M2 money supply since March of last year is the sharpest decline in money growth since the Great Depression of the 1930s. The Fed’s monomaniacal focus on labor market tightness is thoroughly misguided. Average real hourly wages have been down over since the Pandemic began and the pace of nominal wage growth severely lags behind the pace of inflation across food, fuel, shelter, and other key household spending. Put more simply, it is hard to argue that wages are causing inflation when wages are rising less than inflation.

Chairman Powell has conceded that there has been a downward structural shift in the labor force. Economics 101 dictates that this means real wages have to rise to induce individuals into the workforce. It is wrong for the Fed to use “demand management” to try to solve a supply-side problem.

The Fed warns that rising wages in the service sector will worsen inflation. But anyone waiting for service in a restaurant or other venues can easily see: higher wages are needed to induce more workers into these jobs so that consumers can get finally get service in the “service” sector! Blaming of inflation on labor market tightness reflects an obsolete Phillips Curve mentality which even Fed Chair Jay Powell disparaged earlier in his tenure, before he apparently forgot his own utterances.

The Fed is too worried about having to prove their mettle and so wounded for being late and dismissive over inflation in 2021 that they are still fighting the last war–not realizing that there is now pervasive disinflation across virtually the entire economy. High mortgage rates have slowed new housing activity to a crawl. Many commodities are down 70% from peaks just last year across the agricultural and metals complex as traders now openly fret about commodity oversupply, and shipping and cargo rates have collapsed as consumers are about to exhaust their savings left over from the pandemic.

Continuing to tighten monetary policy in this environment of bank blowups and declining consumer and business confidence is a surefire recipe for disaster. The focus should now turn to combatting what remains of residual inflation through non-monetary policy responses, ranging from increasing labor supply to policy fixes that bring down consumer costs and increase market competition. These are precise, supply-side solutions that will help increase supply through targeted fixes, without the collateral damage and general carnage wrought by the Fed’s indiscriminate rate hikes.

Clearly, as the Fed prepares for its FOMC meeting in just two weeks, it needs to realize that it has now oversteered the economy to the precipice–and that it needs to pause further rate hikes. Powell himself has acknowledged that monetary policy works with a lag but complains that he has not seen enough progress against inflation, although the Fed’s first rate hike occurred less than one year ago. The full impact of one of the most rapid tightening policies in Fed history is yet to be felt. Maybe now, with the collapse of SVB and other banks, the Fed will realize that its impatience risks dire consequences for the whole economy.

Department: Faculty Viewpoints