As banking turmoil ripples around the world, government officials in many nations are suddenly confronting a two-pronged problem: how to fight inflation with one hand while bolstering financial system stability with the other.
These tasks are hard enough on their own. Added difficulty stems from the fact that typical solutions for them can work at cross-purposes. Raising interest rates to fight inflation can slam banks in some circumstances. Keeping rates low may calm financial institutions but fuel the fire of rising prices.
Why We Wrote This
How can officials both tame inflation and ensure bank stability? It’s a difficult balance that for now, at least, appears to still include interest rate hikes.
That’s left regulators from Frankfurt to Washington facing a clash of values. Is one of these problems worse than another? Must they be fought separately?
To this point one thing seems clear: Central banks are reluctant to roll back anti-inflation measures, as prices haven’t been tamed as much as they would like. On Thursday, the European Central Bank announced it was going ahead with a half-point interest rate increase.
If the bank had canceled the hike, it might have signaled to the markets that the banking system is in worse trouble than it seems, says Jon Danielsson at the London School of Economics.
“The best way not to panic the markets is to go ahead with an interest rate increase that had already been expected by everybody,” he says.
Next week, the U.S. Federal Reserve must do its own weighing of the balance when it meets to decide whether to raise interest rates yet again.
As banking turmoil ripples around the world, government officials in many nations are suddenly confronting a two-pronged problem: how to fight inflation with one hand while bolstering financial system stability with the other.
These tasks are hard enough on their own. Added difficulty stems from the fact that typical solutions for them can work at cross-purposes. Raising interest rates to fight inflation can slam banks in some circumstances. Keeping rates low may calm financial institutions but fuel the fire of rising prices.
That’s left regulators from Frankfurt to Washington facing a clash of values. Is one of these problems worse than another? Must they be fought separately? Can they be addressed together?
Why We Wrote This
How can officials both tame inflation and ensure bank stability? It’s a difficult balance that for now, at least, appears to still include interest rate hikes.
To this point one thing seems clear: Central banks are reluctant to roll back anti-inflation measures, as prices haven’t been tamed as much as they would like. On Thursday the European Central Bank announced it was going ahead with a half-point interest rate increase. U.S. Secretary of the Treasury Janet Yellen, appearing before the Senate Finance Committee, said the American banking system remains sound.
Recent bank failures may have made it more difficult for the U.S. Federal Reserve to raise rates, says Dave Schabes, a University of Chicago Harris School of Public Policy expert on banking and finance. But currently the Fed seems determined to forge ahead.
“I have found [Federal Reserve Chairman Jerome Powell] and most other Fed board members very clear that rates may have to rise higher and longer than the market might like,” says Professor Schabes in an email.
An uneasy equilibrium
On Thursday world financial markets seemed to have settled into an uneasy equilibrium.
Investors appeared encouraged that Credit Suisse, a struggling Swiss bank whose outlook deteriorated earlier this week following the collapse of two U.S. banks, had secured a $50 billion lifeline from the Swiss National Bank. Also, big U.S. banks agreed on a $30 billion rescue package for First Republic, a smaller American institution that, like Credit Suisse, has been battered by a decline in investor confidence.
Meanwhile, Secretary Yellen told senators that the U.S. depositor rescue plan, which permitted the Federal Deposit Insurance Corp. (FDIC) to guarantee deposits at banks that collapsed in recent days beyond the $250,000 limit per customer, had stemmed fallout from the sudden shake-up in the banking system.
No matter how strong government regulation is, a bank can face failure if it is subject to an “overwhelming run” on its deposits spurred by social media, Ms. Yellen said. Regulators stepped in following the collapse of Silicon Valley Bank to prevent other banks from facing similar runs.
In Frankfurt, Germany, European Central Bank (ECB) President Christine Lagarde announced at a press conference that the bank was going ahead with a half-point increase in interest rates, despite some investor sentiment to delay the hike.
Recent data on inflation has shown that prices are still climbing faster than regulator targets, said Ms. Lagarde.
“Inflation in Europe is quite high. And it’s important for the ECB … to be seen as a strong fighter of inflation,” says Jon Danielsson, director of the Systemic Risk Centre at the London School of Economics’ department of finance.
If the bank had canceled the hike it might have signaled to the markets that the banking system is in worse trouble than it seems, says Dr. Danielsson.
“The best way not to panic the markets is to go ahead with an interest rate increase that had already been expected by everybody,” he says.
The bank unraveling, explained
But raising interest rates can stress banks, particularly if they are not properly prepared. That is one of the reasons that Silicon Valley Bank and Signature Bank in New York were seized by U.S. financial regulators in recent days.
Consider a notional bank that has grown very fast in recent years, as did SVB. It takes its flood of new depositor cash and invests a large percentage of it in long-term Treasury bonds – again, as was the case with SVB.
Treasury bonds are the gold standard of investment, backed by the U.S. government. So, this notional bank would be gold itself, right?
Maybe. However, until relatively recently the interest on long-term bonds has been very, very low. Since the pandemic, that’s changed. The Fed has quickly ratcheted up rates to try to cool the economy and thus cool inflation.
That erodes the value of older long-term bonds, because newer bonds are offering higher rates of return. If the bank has a lot of them, and they have to sell them quickly to raise cash, they will start to lose money. They can be in trouble, fast.
That’s a simplistic description of what happened to SVB. The addition was a core of herdlike, well-informed, wealthy tech and venture capital depositors. Some of them noticed that the bank had troublesome Treasury bond investments. They took their money out, and told others about the problem. Suddenly the bank had a run – and had to sell more Treasury bonds, incurring more losses, to raise cash to pay depositors.
SVB was clearly an outlier. But there might be other financial institutions with similar problems, says Dr. Danielsson.
“There are quite possibly a lot of other banks, not quite as extreme, but also vulnerable to increasing interest rates … on both sides of the Atlantic, even more in Europe,” he says.
Probably not another 2008 crisis
This does not mean the United States and the world are necessarily headed toward another 2008 financial crisis, or anything like it.
The largest U.S. and European banks are much better capitalized than they were going into 2008, says Professor Schabes.
“The issue that will likely be revisited will be smaller banks’ capital and risk management requirements,” he says. “It seems that at least in the case of SVB, inadequate interest rate risk management was part of the problem.”
In the real world banks use many tools to spread the risk of bond holdings, from “laddering” by mixing in Treasury bills of different maturity dates, to diversifying into other types of assets entirely.
Some experts blame the Federal Reserve for not noticing the risk of banks like SVB that were heavily invested in Treasury bonds when interest rates began to rise. Dror Goldberg, an expert in monetary economics and author of “Easy Money: American Puritans and the Invention of Modern Currency,” says the turmoil of the past week could, and perhaps should, pave the way for more government “stress tests” for banks in the future.
“These are really critical days,” he says, which is why the Fed, FDIC, and Treasury are doing all they can to reassure the population.
Mr. Goldberg believes that the U.S. should avoid the understandable temptation to give up the fight against inflation. Some other experts believe that framing the current moment as a two-horned dilemma between fighting inflation and stabilizing the financial sector is misleading.
“The Fed should not be doing these [interest] rate hikes anyway,” says Robert C. Hockett, law professor at Cornell Law School focused on financial and monetary law.
That is because what the U.S. is dealing with now, says Mr. Hockett, is a shortfall of production since the pandemic, including supply chain bottlenecks, and profits that are rising faster than inflation. Those issues require other types of responses to incentivize production and prevent price-gouging, he says.
He also supports raising the current $250,000 limit on federal deposit insurance – one of the few banking reform proposals currently drawing some bipartisan support in Congress.
The reality, though, is that interest rate hikes remain the go-to tool of government regulators around the world to battle the resilient inflation problem.
In the U.S. the Fed remains committed to raising rates and promoting financial institution stability simultaneously.
“The Fed is going to try to treat the two threats in parallel. It’s a titanic task,” says Santiago Bulat, economics professor at the University of Buenos Aires.