The Fed’s Dilemma: Fight Inflation or Save Failing Banks

The Fed’s Dilemma: Fight Inflation or Save Failing Banks
Federal Reserve Board chairman Jerome Powell speaks during an interview by David Rubenstein, chairman of the Economic Club of Washington at the Renaissance Hotel in Washington on Feb. 7, 2023. Julia Nikhinson/Getty Images
Kevin Stocklin
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News Analysis

The Federal Reserve has painted itself into a corner with its fight against inflation, and some experts say it now has no coherent plan for how to get out of that predicament.

Having kept interest rates near zero for more than a decade and expanded its balance sheet to $9 trillion to stimulate the economy, the central bank is now facing a banking system that has become so dependent on cheap money that its sudden withdrawal may be killing the patient.

William McChesney Martin, Fed chair from 1951 to 1970, famously said that the role of the Fed was “to take away the punch bowl just as the party gets going,” in other words, to cool the economy by raising rates before it begins to overheat. To follow that analogy, however, current Fed Chair Jerome Powell is now attempting to kill the party well past the morning after.

“They have wasted long periods of time to correctly detox,” economist Arthur Laffer told The Epoch Times. Laffer believes that more bank failures are likely on the horizon, which is making Powell think twice about raising rates further, but “there will be a lot more collapsing if they don’t do it.”

“Banking systems can’t operate without markets functioning,” Laffer said. “Take me back a year and half, when the 30-day T-bill was zero, when the long bond was 1.5 percent, and inflation is running at 7, 8, or 9 percent, and tell me that’s markets operating? It’s not.”

‘The Party Is Over’

Economist Nouriel Roubini, renowned for predicting the 2008 mortgage crisis, said in a Frontline interview—which is no longer available—that “we have had literally a few decades of ever-increasing bubbles that have been fed and supported by central banks ... that have been fed by excessive leverage, excessive private and public borrowing, and excessive risk-taking. The party is over.”

“This dream in a bubble is bursting and is turning into an economic and financial nightmare.”

What is becoming increasingly apparent is that many banks have built their strategy on cheap money and aren’t prepared for that era to end. Bank failures began with the most fragile banks, such as Silicon Valley Bank (SVB), which failed on March 10, and have now spread to much larger so-called global systemically important banks such as Credit Suisse, Switzerland’s second-largest bank. Most recently, the health of Deutsche Bank, Germany’s largest bank, has been called into question.
On March 22, the Fed announced its latest rate increase, a 0.25 percent boost in short-term rates. That’s a smaller increment than what the Fed has been doing over the past year, when rate increases had come in increments as high as 0.75 percent.

Inflation Fighting and Bank Failures

Former Treasury Secretary Larry Summers highlighted the precarious balance of fighting inflation and shoring up struggling banks.
“I probably would have allowed more room for concern about inflation and left the door a bit more open to multiple rate hikes, given the strength of the recent inflation data,” he said of the Fed’s latest rate increase. “But it’s a very close call, and I think what they did was entirely reasonable. A lot is going to depend on how the regulatory authorities and the bank insurance authorities deal with the remaining bank problems out there and what happens in the banking system.”

Even as it continues to increase interest rates, however, the Fed has simultaneously reversed a policy, known as “quantitative tightening,” of steadily selling off the massive holdings of bonds it has been buying since 2008, which is now returning toward its peak level of nearly $9 trillion. This shift would likely fuel inflation by pushing longer-term interest rates down.

The accumulation of bonds by the Fed as part of its "quantitative easing" strategy. (The Federal Reserve)
The accumulation of bonds by the Fed as part of its "quantitative easing" strategy. The Federal Reserve

Powell pursued his quantitative tightening strategy “only until the first scream,” Laffer said. “And he got the first scream with less than half a trillion sold. I think the height it got to was $8.8 trillion, and now it’s down to $8.6 trillion.

“That 200 billion caused squeals beyond belief, bankruptcies, runs on banks, all that.

“We have not even scratched the surface of where we should go.”

Roubini illustrated the magnitude of banks’ problems with rising rates. Normally, in times of economic distress, banks shift their investments into “safe” assets such as highly rated government bonds.

Today, he said, “safety is not in long-term Treasurys. ... If average inflation were to be, say 5 percent, 10-year Treasurys eventually would have to be 7 percent; today they are 3.5.” Because of rising rates, the value of fixed-rate bonds fell in 2022, causing huge losses for banks that held them.

“Last year, you lost 20 percent on your safe bonds, more than you lost on your S&P [stocks], because the yield went from 1 [percent] towards 3,” he said. “If they go from 3.5 to 7 ... there'd be a further bloodbath on $20 trillion long-duration risk assets.” Banks currently have more than $600 billion in unrealized losses on these fixed-income securities at current interest rate levels, he said.

Trial-and-Error Monetary Policy

The Fed today is in uncharted territory, and some say the central bank lacks a coherent plan of how to get the United States’ economy back on sound footing, opting instead for a trial-and-error approach of making adjustments and seeing what happens.

“These people don’t understand what they’re doing,” Laffer said. “Jerome Powell is not an accomplished theoretician on money and banking. He doesn’t have much experience in it, either. And yet he’s facing one of the most serious decision-making situations ever.

“He doesn’t have the requisite tools to be able to make the right decisions. And I don’t just mean him, but the whole board.”

When the policy of quantitative easing started in 2008, buying trillions of dollars of bonds was an experimental effort that was attempted because the Fed had already driven short-term rates to zero and couldn’t bring them down further. At the time, Fed officials acknowledged they weren’t sure whether, or how, it would work.

“The problem with [quantitative easing] is it works in practice, but it doesn’t work in theory," Then-Fed Chairman Ben Bernanke said. Now that they are attempting to reverse it, they still aren’t sure.

Beyond that, even after one of the fastest series of rate increases in a generation over the past year, interest rates are still in negative territory, meaning below the inflation rate. The official rate of inflation is currently about 6 percent and rising; the federal funds target range is 4.75 to 5 percent. Even as the Fed continues to state its intentions to slow inflation, negative interest rates, combined with an expanding Fed balance sheet, means that monetary policy is still stimulative.
Interest rates have historically been above inflation until the period of "quantitative easing." (Federal Reserve)
Interest rates have historically been above inflation until the period of "quantitative easing." Federal Reserve

Banks Losing the Public’s Trust

While inflation remains a chronic problem, bank regulators must now also cope with depositors’ faltering trust in the banking system. Because banks invest a substantial amount of their deposits in longer-term assets, such as loans or bonds, the banking system can’t survive too many simultaneous demands by depositors for their money. For this reason, maintaining the public’s trust that their deposits are safe and as good as cash is essential to avoiding bank panics that could lead to systemic collapse.

“Once you start a run,” Laffer said, “it’s a different game.” For that reason, he supports the decision by bank regulators to guarantee all depositors, during tense weekend meetings following SVB’s failure.

“That Sunday night, I think [Treasury Secretary Janet] Yellen was correct,” Laffer said. “Given that this thing was going to explode on Monday morning, if they didn’t guarantee the depositors, the run would be on, and there is no limit to how far that run goes.

“The only way to stop a run on the banks is to have a guarantee of depositors on the spot. And you can’t wait a week, because it’s gone, it’s over in a week.”

Going forward, however, the goal should be “to ameliorate the short-run financial collapse but allow the incentive structure to be correct,” Laffer said. “All investors in the banks, whether they be bondholders or stockholders, should suffer the entire consequences of the losses, period.”

Guaranteeing all bank deposits, however, creates the risk that depositors will simply go where they can get the highest interest rates, without having concern for how risky the bank may be or how concentrated their savings are within any one institution. As a result of SVB, Signature Bank, and others whose depositors were bailed out, everyone with a bank account will now contribute, through higher deposit insurance premiums, to repay companies and wealthy individuals who lost more than $250,000.

Author and economist Peter Zeihan said the bailout of large depositors “has injected a permanent level of stupidity into the financial system.” Guaranteeing depositors beyond $250,000, he said, “does put a hard stop on any risk of a bank run. ... But it [also] encourages companies that have done stupid things like this to continue doing them, because now all of us have to pay through lower bank interest or more difficult loan conditions for a handful of startup companies who had CFOs who were just too dumb to realize that there was a limit to the deposit insurance system.”

Fed on Its Own in Inflation Fight

One problem that the Fed has in attempting to quell inflation is that it’s on its own in this fight. In the 1980s, when then-Fed Chairman Paul Volcker pushed rates up to almost 20 percent to bring down double-digit inflation, he was doing so at a time when President Ronald Reagan was cutting taxes and deregulating the economy, thus boosting the supply of goods and services. Inflation was reduced in short order by simultaneously reducing demand and increasing supply, bringing the economy back into balance.
During the Biden administration, however, additional regulations and anti-fossil fuel policies have restricted the supply of goods, driving up prices further. A report by the American Action Forum, which tracks the scale of government regulation, states that the Biden administration has implemented 532 new executive orders and regulations, at an estimated cost of $359 billion. By comparison, the cost of new regulations during the Trump administration was $6.8 billion.

The only tool the Fed has to fight inflation, working by itself, is crushing demand through higher interest rates.

If rates are pushed high enough, there will be lower inflation, Laffer said.

“But we’ll get lower inflation with a lot lower output, employment, production—and a lot more despair and hardship.”

A supply-side approach of reducing taxes and regulation, by contrast, will “increase the supply of goods and shift the supply curve out rather than the demand curve back,” he said. “You choose which model you prefer.”

Kevin Stocklin
Kevin Stocklin
Reporter
Kevin Stocklin is an Epoch Times business reporter who covers the ESG industry, global governance, and the intersection of politics and business.
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