Column: The Fed’s mistakes have pushed the economy to the brink of recession. Another rate hike could kick this into high gear

The Federal Reserve system was hit in late 2021 when it labeled the signs of rising inflation as “temporary” and delayed taking strong measures to contain inflation.

Since then, the central bank has been fleeing from its critics. Under its chairman Jerome H. Powell, it enacted its most aggressive anti-inflation hikes in more than 40 years, as if to make up for its initially belated response to a nearly year-long price recovery.

In doing so, however, the Fed has damaged bank balance sheets that could have a lasting negative impact on economic growth beyond what would be felt even during a sustained period of high inflation.

The Harvest is a banking crisis sparked by the collapse of Silicon Valley Bank (SVB) on March 10 and the subsequent run on several other banks in the US and abroad believed to be in need of bailouts.

As Fed officials prepare for a two-day meeting where they will decide whether to raise rates, or by how much, Fed watchers expect the bank to slow the pace of its recent rate hikes by publishing an announcement of an announced hike of only a quarter of a percentage point on Wednesday. That would bring the total profit to 4.75 percentage points in just one year.

Some economists and policy experts are advising that the bank should not raise rates at all this week or it could plunge the economy into recession.

There are several reasons for this: the Fed’s rate hikes have already yielded signs of a slowing economy, businesses and households that received money from government bailouts last year have depleted their financial buffers, and it is almost certain that the banking crisis will be over. provoked. banks to tighten their credit conditions, further hampering economic growth.

“The interest rate shock is still there… and we still have the banking crisis and we have a lower savings stock,” Ian C. Shepherdson, chief economist at Pantheon Macroeconomics, said in a webcast Monday. “I’m one sleepless night away from changing my main macroeconomic forecast from no growth to outright recession, and if that’s the most likely outcome, why on earth would the Fed keep raising rates?” , he would say to them, “Please don’t.”

Former FDIC Chair Sheila Bair, who served during the 2008 banking crisis, added her voice to the chorus in an interview with CNN. “The Fed needs to pause and assess the full impact of its actions to date before raising short-term rates any further,” she said. “If they pause, it will have a leveling effect on the markets.”

Economists’ concerns about the size and speed of the Fed’s rate hikes have been mounting for months. Former Fed economist Claudia Sahm has long warned that “the big and rapid rate hikes by the Fed over the past year will destroy something in the financial markets,” as she wrote on her blog last week. “The malaise at the SVB and the possible contamination effects fit the picture.”

There is reason to believe that the battle against inflation has largely been won, albeit at a certain economic cost. Two key drivers for price increases in 2022 — a spike in oil prices following Russia’s February 2022 invasion of Ukraine and pressure on global industrial supply chains as pandemic shutdowns ended and demand recovered — have disappeared.

Corporate lending is slowing, house prices continue to fall, wage growth is slowing and industrial production is shrinking. These measures all point to a deflationary slowdown.

The Fed’s difficulty in coping with last year’s economic turmoil stems in part from its many conflicting responsibilities.

Economically, the most important of these is the so-called “dual mandate” – promoting maximum employment and price stability. That means using its authority over monetary policy to control inflation and promote “the highest level of employment that the economy can maintain over time,” as the Federal Reserve Bank of St. Ludwig does.

These objectives are generally considered to be complementary, as low and stable inflation tends to support employment growth. There are times when they can come into conflict, for example when aggressive anti-inflation policies lead to higher unemployment. It’s a prospect put forward by Fed critics during last year’s aggressive rate hikes aimed at lowering inflation by slowing the economy, which has begun with mass layoffs in high-tech and other sectors.

Then there’s the role of the Fed as the primary overseer of much of the banking system, especially bank holding companies (which own nearly all commercial banks of all sizes) and many state-licensed banks. The central bank’s role here is to protect the “safety and soundness” of individual banks and the banking system as a whole.

Over the past year, there has been much resistance to the Fed’s role as an anti-inflation supervisor and banking regulator. Since last March, it has made first-responsibility its priority, paying very little attention to how its rate hikes — the fastest rate since Fed Chairman Paul Volcker launched the 17-month period in 1979-80 — erode the security of affected banks and will affect reliability.

The Fed seems to have overlooked the fact that the rate hikes would create a very different problem for banks than the ones that brought the banking system to the brink during the financial crisis of 2007-2009.

Then the burst of the US housing bubble destroyed the value of mortgages and mortgage-backed securities held by banks, many of which were overvalued to begin with.

The remedy mandated by Congress and the Fed was to force banks to rebuild their capital buffers by reducing the amount they could lend in multiples of stocks and deposits and lowering the quality of the loans they made. Among other things, the subprime mortgage market – loans to homebuyers that would not qualify for mortgages under traditional terms – has all but been wiped out.

By that measure, U.S. banks are much healthier today than they were 15 years ago. That included Silicon Valley Bank at the time of its collapse and takeover by the Federal Deposit Insurance Corp. On March 10.

However, the roots of the current crisis are very different. The SVB’s problem was not risky loans or bad assets. The nearly $194 billion in property, plant and equipment through the end of 2022 included nearly $116 billion in undisputedly safe U.S. and foreign government bonds, as well as nearly $14 billion in cash and an additional $74.3 billion in outstanding loans.

That should have been more than enough to cover the bank’s $173.1 billion in deposits. The problem, as we reported earlier, is that the bank bought most of these government bonds at the peak of the bond market, when interest rates were close to zero and bond prices therefore had nowhere else to fall. Earlier this year, they were worth much less than the bank paid for them.

But it shouldn’t matter much. The securities held were classified into two categories: approximately $25.3 billion was listed as “available for sale,” meaning that the impairment had to be recognized on the bank’s balance sheet, and $90.6 billion as “held until expiration date”.

According to accounting rules, the latter can be valued at cost since, once they reach maturity, they are deemed to be worth the price paid plus interest. At the end of last year, unrealized losses on the held-to-maturity portfolio — which would only matter if the securities had to be sold before maturity — totaled nearly $15.2 billion.

The unexpected factor that caused the bank’s collapse was that its deposits were heavily concentrated in one sector of the economy – venture capital-backed companies in high technology and biotechnology. When venture capitalists advised their portfolio companies to withdraw their deposits from SVB, resulting in a one-day outflow of approximately $42 billion, the embedded losses became relevant.

This is the situation that the Fed seems to have overlooked. She can be sure that the SVB and other banks with similar balance sheets met the post-Great Recession capital requirements. But it failed to adequately monitor the combined effect of a collapse in the value of long-term investments and a sudden flight of deposits.

The Fed fought the last war when risky, overvalued credit brought the banking system to its knees, but not the current war, in which the enemy was its own campaign to raise interest rates (and thus the long-term effects of collapsing values). ) to prevent inflation.

The Fed, Treasury and FDIC administered the only drugs they deemed appropriate in this context. They enable troubled banks to borrow from the Fed by valuing their long-term bonds against their maturity value as collateral. (The FDIC also agreed to insure the entire balance of deposits with these banks, rather than just up to the $250,000 limit per depositor, to stem the impulsive flight of deposits from all but the largest banks.)

However, another rate hike by the Fed on Wednesday will only complicate the whole process. Securities held by banks will depreciate more, and savers may become more nervous about holding their money in medium-sized or small banks.

The Fed’s performance over the past year has been a series of interacting, self-reinforcing failures. Initially, the Fed and Chairman Powell underestimated the duration and intensity of inflation (and misunderstood its causes). Then they overreacted, driving interest rates higher and faster than the economy could handle, never stopping to check how their actions worked.

Meanwhile, they averted their eyes from banking supervision. It’s true that in 2018, banks the size of the SVB were given exemptions from a lot of post-recession regulation, including the mandate to undergo “stress tests” that could have shown how rising interest rates would affect their balance sheets. But nothing stopped the Fed from proactively passing judgment on the health of the SVB. It didn’t.

“The ‘temporary’ fiasco was a fiasco for everyone,” says Shepherdson. “The Fed’s institutional reputation and Powell’s personal reputation have taken a beating from both sides of the aisle, from the media and from the markets, and they can’t be wrong again… It would be a would be a mistake to continue rates to increase this week, and the cost of not increasing this week is very small.