The Fed’s Many-Headed Dilemma
To fulfill its dual mandate of pursuing maximum employment and low inflation, the Federal Reserve must navigate economic uncertainty and the intense political attention its decisions always draw. According to Prof. William B. English, a former Fed official, when Silicon Valley Bank collapsed and sent ripples through the financial system, the central bank’s “hard job just got even harder.”
Have the Fed's actions to control inflation contributed to the bank failures and banking sector stress we have seen in recent weeks?
In part, yes. The immediate cause of the failure of Silicon Valley Bank, which triggered the current banking strains, was a significant decline in the value of its holdings of longer-term government securities. The decline in the value of those securities reflected, in turn, the increases in interest rates that the Fed has put in place over the past year to slow the economy and bring inflation back down to its 2% target.
That said, the underlying problem appears to have been very poor risk management. Silicon Valley Bank was holding an extraordinarily large amount of longer-term government securities. Such holdings could have been appropriate if the bank had a very stable, low-cost deposit base – for example, lots of deposits from a broad range of households, mostly under the FDIC insurance limit of $250,000. However, Silicon Valley Bank’s deposits mostly came from high tech firms and were largely above the insurance limit. When performance in the tech sector deteriorated last year, those firms drew money from their accounts, and Silicon Valley Bank had to sell some of its securities at a loss to fund the withdrawals. The announcement of those losses led uninsured depositors pull their money out, causing the bank to fail.
Other similarly situated banks – those with significant exposures to the tech sector, substantial uninsured deposits, and large holdings of longer-term government securities – came under pressure as a result of the problems at Silicon Valley Bank, with one, Signature Bank, also failing.
How do the failures of Silicon Valley Bank and Signature Bank complicate the Fed's task?
The Fed will need to monitor the economy, and particularly the behavior of banks, over the coming weeks and months to try to assess the effects of the banking stresses.
The stresses on banks over the past couple of weeks are likely to constrain bank lending. Those banks that are directly affected will lend less as result of actual or potential withdrawals of deposits, as well as concern about the adequacy of their capital. And even banks not directly affected will be concerned about deposit withdrawals spreading, and so will want to be more cautious regarding liquidity and risk. The result will be tighter bank lending standards and terms, which will, in turn, reduce spending by bank-dependent borrowers – including households and small and medium sized businesses – and so slow growth.
As a consequence, the Fed won’t need to raise rates as much to slow the economy and bring down inflation. Indeed, markets have already priced this in. But the banking problems have generated a lot of uncertainty about the outlook for the economy and so for monetary policy. On the one hand, the strong actions by the FDIC, Fed, and Treasury to address the problems may mean that the stresses on banks are fairly narrow and ease relatively quickly. In that case, the economy will not be greatly affected, and the Fed would likely need to raise rates significantly further to achieve its goals. On the other hand, many banks may be spooked by the recent events, and so pull back more aggressively from lending, causing the economy to weaken significantly. While that might be helpful for the Fed’s inflation goal, it could mean that the Fed will be easing policy before too long to avoid an undesirably large slowdown in economic activity.
The Fed will need to monitor the economy, and particularly the behavior of banks, over the coming weeks and months to try to assess the effects of the banking stresses and appropriately calibrate monetary policy. In short, the Fed’s hard job just got even harder!
How do you interpret the Fed’s actions at this week’s meeting?
Prior to the banking problems, the Fed was seen as likely to raise its policy rate by a half percentage point at this week’s meeting. In the end, the Fed chose to tighten by only one quarter percentage point. In addition, it suggested that it might be close to the end of its policy tightening and emphasized the uncertainty around the outlook. These actions reflected an effort to balance two risks.
On the downside, if the Committee had left rates unchanged at this meeting to buy time and get more information about the banking situation, that could have wrongly been seen as a signal that it was done raising rates, and there could have been a big rally in markets and a loss of inflation-fighting credibility. Moreover, staying its hand could have been seen as suggesting the Fed was very worried about conditions in the banking sector, and so doing so might have undermined confidence and caused difficulties for more banks.
On the upside, however, a half percentage point increase at this meeting could have made the situation worse. If the banking strains proved larger and more long lasting than anticipated, the result would be an even deeper recession. Moreover, such a large move could suggest that the Fed was insufficiently worried about the banking problems, and so increase the risk of runs on other banks and a broader banking crisis.
By the time of the meeting, markets appeared to anticipate a quarter percentage point rate hike, and some of the banking strains appeared to be easing. Against that backdrop, the Committee may have seen benefits to not surprising investors and running a risk of destabilizing the banking situation, and so it delivered the expected change in rates, noted the uncertainty we face, and emphasized that if banking developments go poorly—or go well—the Committee will adjust policy accordingly.