The Fed’s Interesting Policy Dilemma

By Finn Watson

With inflation still strong and the banking sector reeling from higher interest rates, Fed policymakers are stuck between a rock and a hard place: should they continue to raise rates or prioritise financial stability?

The Banking Crisis:

March has been a frantic month for banks and financial regulators. It began with the highly reported collapse and insolvency of Silicon Valley Bank which was subsequently subsumed by the FDIC on March 10th. While SVB was undoubtedly an outlier in terms of its exposure to interest rate and liquidity risks, governance, and overall risk management strategy, its collapse produced a sudden drop in confidence across the banking sector and had many investors looking for who could be next. Investors found what they were looking for at Signature Bank which experienced a run and became insolvent, getting the FDIC treatment on March 12th. Both banks got their deposits – insured and uninsured – protected by the FDIC. Growing anxiety in the markets spread overseas affecting the controversy-riddled Credit Suisse where liquidity concerns ultimately resulted in its acquisition by UBS. During this period, anxieties were directed in many places across the finance sector, from First Republic Bank and others in the US to European Banks such as Deutsche Bank, Societe Generale, Commerzbank, and Raiffeisen Bank.

The Buffet quote “Only when the tide goes out do you discover who’s been swimming naked,” describes many aspects of the most recent banking scare. In this case, the tide is referring to the strong and steady policy rate hikes that have been pursued by central banks across the world this past year in an attempt to quell inflation. With these rate hikes being the largest and fastest in the past 40 years and coming after an extended period of ultra-low rates, it’s not surprising that many banks are having trouble dealing with the changes. 

Although it may seem that banks would welcome higher rates because they can now issue loans with considerably higher yields, it isn’t necessarily that clear-cut. These higher yields are offset by reduced lending volumes as well as diminishing fee revenue from refinancing and new loan creation. Furthermore, because banks have large pre-existing portfolios of securities (mainly bonds and other debt instruments) when interest rates rise, these portfolios can see massive unrealized losses which may be written down. In this way, the banking sector is sitting on more than $620 billion dollars in unrealised losses. These losses are only problematic if banks sell the assets before maturity and realise the loss. This is precisely what happened to SVB and other financial institutions that experienced bank runs as deposits headed to money markets and the big banks deemed safe on account of their ‘too big to fail’ designation. Deposit outflows from these weak institutions caused them to sell these assets to meet the deposit outflows thus realising the losses and legitimising fears.

While the tide has gone out catching SVB, Signature Bank, and others without proper attire,

the Fed and other monetary authorities must act cautiously, careful of what other things could lay below the water line.

The Fed’s Response and Dilemma:

In response to the banking failures, financial authorities in the US took particularly strong steps to mitigate the acceleration of the crisis and central banks around the world stepped in to provide much-needed liquidity to banks.

The Fed took the strongest steps to shore up stability in financial markets by introducing a new lending facility designed to provide more favourable conditions for lending than the discount window. This facility called the Bank Term Funding Program (BTFP) had a key feature, that collateral would be valued at par instead of at market value so that Banks borrow against the portfolios severely weakened by the interest rate hikes of the past year. Although the BTFP offered attractive lending conditions when compared to the discount window, Banks have favoured the discount window over the BTFP. This is partially because of the larger range of collateral accepted by the discount window as well as the stigma of using this new facility. As other market participants can piece together information to figure out who is using the facility, using the facility signals to others that an institution is in distress and increases its exposure to anxiety and ultimately to accelerated deposit outflows.

Instead of the BTFP meeting the liquidity needs of the banking sector, these needs were met through the discount window, causing an expansion of the once shrinking Fed balance sheet and undoing much of the anti-inflationary quantitative tightening that was previously Fed policy. Since March of last year, when inflation was elevated as the primary concern for policymakers, the Fed has been reducing the size of its balance sheet significantly in an attempt to reduce liquidity and the money supply to assist in curbing inflation. During the year between March 2022 and 2023, the Fed’s balance sheet fell over half a trillion dollars. However, in just two weeks between March 8th and 22nd, nearly two-thirds of the previous quantitative tightening was undone to support banks. This constitutes part of the policy dilemma that the Fed is facing because if financial instability persists and Fed facilitated liquidity is necessary to restore the sector, it eliminates quantitative tightening as an effective inflation fighting tool.

Furthermore, since much of the current financial instability originated in interest-rate risk accumulating in parts of the financial sector, it’s questionable how much farther the hikes can be taken without further endangering the health of the financial sector. The Federal Reserve (as well as the BoE) raised rates by 25 bp in March but indicated that hikes may come to an end with Powell suggesting that the conditions in the banking sector led to a change in outlook. However, inflation remains worryingly sticky, sitting at 6% in the US and even higher in the UK at around 10%. This suggests that many more interest rate increases would be necessary to bring inflation down to the 2% target that most central banks aim for.

An additional element of the Fed dilemma is the high possibility of a credit crunch or a sudden stop in lending. In part, this is what the Fed is aiming for as a slowdown in lending volumes significantly reduces inflationary pressures. Such a credit crunch is already partially visible as bank loan volumes have significantly decreased following the SVB fiasco. Falling loan volumes are mainly felt by SMEs and put downward pressure on demand, edging the economy towards recession. Thus, it is vital that the Fed minimises the recessionary pain felt during a credit crunch even though it will help to reduce inflation.

With inflation still strong and the economy and financial sector showing real signs of strain as a result, balancing the goals outlined in the Federal Reserve Charter of financial stability, maximum employment, and minimal inflation will be difficult going forward especially where interest rates are concerned. 

The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.

Photo by Nik Shuliahin via 

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