Last week, the Federal Reserve’s biggest concern was a stubbornly high inflation rate and how much to crank up monetary policy tightening.
In recent days, a new bogeyman emerged in the form of a trio of bank failures and the chilling specter of a financial crisis.
To stave off the latter, the Fed offered a solution that seemingly contradicted its hawkish flight path: looser purse-strings.
On Sunday, the central bank announced the creation of the Bank Term Funding Program, which will provide one-year loans to banks, credit unions and other financial institutions that offer up collateral such as US Treasuries, agency debt and mortgage-backed securities.
Those investments are typically safe, but have crumbled in value during the Fed’s aggressive rate-hiking campaign. Banks were sitting on about $620 billion in unrealized losses at the end of last year, according to the FDIC. So the Fed’s new facility would let banks swap them out for a loan of up to one year worth the original value of the assets they’re ponying up as collateral.
The Fed is engaging in a bit of ‘push and pull’ by offering this liquidity option at a time when it seeks to cool the economy, but the potential benefits of stepping in outweighed the risks, economists say. The program is designed to be used in an emergency to stave off the next SBV from failing — not to kick off a new era of free spending.
“The BTFP is a form of monetary easing, but only to forestall what otherwise might have been a liquidity crisis in the banking system and a severe tightening in monetary policy,” said Mark Zandi, chief economist at Moody’s Analytics. “I don’t think the BTFP will ultimately result in a meaningful increase in bank lending and thus economic growth and inflation.”
By offering emergency funding, the Fed is fulfilling its role, first and foremost, as lender of last resort, said Claudia Sahm, a former Fed economist and founder of Sahm Consulting.
“Well before monetary policy was something they did [the Fed adopted its dual mandate in 1977], the Fed’s primary role was to calm financial markets, step in when there was a potential for bank runs, keep the money flowing,” she said. “Sadly, they’ve had some experience with this in the last 10 to 15 years, with the financial crisis, with the beginning of the pandemic.”
Just in time
While the Fed’s mandate specifies “maximum employment and price stability,” the underpinning factor is financial stability, said Joe Brusuelas, chief economist for RSM US.
That means the Fed can still fight the battle against inflation even while it shores up the banking sector.
“The optics around hiking rates at the same time are clearly not good, but these things are not mutually exclusive, as the central bank addresses a modest financial panic and prevent further bank runs from beginning,” he said.
Although the Fed’s new program is an extraordinary action to ensure bank stability, the Fed is engaged in the lending business every day, Brusuelas noted.
“The Fed buys and sells government securities each day to maintain the range of its policy rate — the federal funds rate — between 4.5% and 4.75%,” he said. “They do this each day and it is normal for the central bank to inject and withdraw liquidity from the market to achieve their policy objectives.”
The launch of the new program might cause a “very minor delay” in the inflation target getting back to 2%, and the Fed may pause temporarily, but the central bank is expected to continue hiking interest rates, he said.
The Fed did this to ensure confidence in the banking system and provide a mechanism to deal with the $620 billion in unrealized losses, according to Brusuelas.
It appears that the action taken by the Fed, Treasury and FDIC this weekend effectively eliminated the risk of the SVB collapse spreading from a debacle into a systemic issue, said Alex Pelle, US economist for Mizuho Americas.
“What previously took months and quarters took policymakers days and hours,” he said in a note Monday afternoon. “As a result, it is unlikely that the economy will experience the traditional credit crunch that we have seen in the last several business cycles in the post-Volcker era.”
‘Bull in a china shop’
The duration and scope of the Fed’s rate-hiking campaign during the past year did cause some unease among economists, Sahm included, that the rapid increases would create weakness in the financial markets.
“If you have a china shop and you do something stupid and release a bull into the china shop, you’re doing to break things,” she said. “SVB was a bull going into the china shop and they made some extremely bad decisions. … But the Fed helped to create this environment that was going to be susceptible to something like SVB showing up.”
The Fed’s rate hikes factored in to Silicon Valley Bank’s collapse in a couple of ways: Higher borrowing costs hurt the sector’s profit and the ability to raise funds, forcing tech companies to draw down on their bank deposits to fund their operations. And the rate hikes undermined the value of the Treasury bonds that banks rely on as a source of capital, Brusuelas said.
However, concentration risk (in cryptocurrency and tech) coupled with lax balance sheet management were the proximate causes of the collapse for SVB, Signature and Silvergate, he added.
“It would seem to me that blaming the Fed here is an exercise in deflecting blame for decisions on the part of management at these banks to borrow short, lend long and not tend to an effective interest-rate risk management strategy,” he said.
Inflation fight on backburner
By offering a discount window to address a liquidity crisis, the Fed put a floor under the banks to stabilize the broader financial system, Brusuelas said. Once that returns, the central bank can shift its focus back to restoring price stability, he said.
“If the crisis intensifies, the Fed would likely lean toward financial stability getting priority for a brief period of time,” he said, noting a further deterioration this week could spur Fed policymakers to pause its rate hikes.
“But by the time we get to the next meeting [in May], I think we’d likely see a resumption of financial tightening by the Fed in terms of further increases.”
At this stage, the Fed’s sole focus is stabilizing financial markets and, in particular, the banking sector, Sahm said.
“What we do next week with interest rates is really beside the point right now,” she said. “If they don’t get this under control, it’s bad. We’re standing on the edge right now, and the implications if we go over the edge are not good.”
CNN’s Matt Egan contributed to this report.
