Separation principle

 

Federal Reserve Chair Jerome Powell finds himself in a place no central banker wants to be: working to avert a credit crunch, which calls for looser monetary policy, while fighting high inflation, which demands the opposite.

Strains in the banking industry, which followed the collapse of three midsize lenders this spring, help explain why some central bank officials are leaning toward holding interest rates steady at their meeting this week—even though the economy and inflation haven’t slowed as much as they expected.

Fed officials don’t think a crisis is imminent, attributing recent troubles to idiosyncrasies at the three banks. But current and former central bankers say if stresses worsen, the Fed will face a more difficult trade off. Powell and his colleagues would have to choose between focusing on failing banks or high inflation.

“They’re between a rock and a hard place. It’s a very, very tough situation,” said Raghuram Rajan, a former governor of the Reserve Bank of India. “You’re damned if you raise rates significantly more and put even more pressure on the banks, but you’re damned if you don’t” and inflation accelerates.

One risk is timing: if inflation becomes entrenched in public psychology, becoming self-perpetuating, that could force the Fed to hold short-term interest rates higher for longer.

“If inflation is going to fall quickly…we might be in a position to be able to cut rates, if not this year, then soon in the new year,” said Minneapolis Fed President Neel Kashkari in an interview last month. “But if, on the other hand, inflation is much more persistent and much more entrenched…then I think the stresses in the banking sector probably become more serious.” 

The economic expansion, the Fed’s credibility and Powell’s legacy are at stake. Powell was appointed to a second term as Fed chair in part because of his popularity in Congress, with his initial response to the Covid shock in 2020 and his handling of President Trump’s attacks earning accolades on both sides of the aisle.

The past two years have been much rockier. First, the Fed misjudged inflation. More recently, the Fed’s performance on bank regulation has come under fire.

Separation principle

During the pandemic, the Fed signaled plans to hold interest rates at very low levels for years and purchased trillions of bonds to spur additional borrowing, and the government poured additional stimulus into the economy. The moves pumped banks full of deposits in 2021.

As inflation hit 9% last year, Powell accelerated interest-rate increases because he and his colleagues wanted to stop an inflationary mind-set from taking root.

By February, the Fed had increased rates by 4.5 percentage points in one year—more swiftly than any time in the past 40 years. 

Bank supervisors didn’t quickly spot how those rising rates had created a dangerous mismatch between some banks’ assets—securities and loans paying low rates—and liabilities—deposits and other borrowing with higher rates. That triggered a run on Silicon Valley Bank in March. 

The Fed and other regulators responded by backstopping the uninsured deposits of SVB and another bank that faced a run, New York-based Signature Bank, on March 12. They also agreed to lend to banks in general on favorable terms, putting money back into the economy.

But with inflation still too high, the Fed’s rate-setting Federal Open Market Committee lifted rates on March 22. They raised them again in early May, to the current range between 5% and 5.25%, just days after regulators arranged a shotgun sale of a third lender, First Republic Bank, to JPMorgan Chase.

In making these moves, the central bankers were operating under their so-called separation principle: They use emergency lending and other regulatory tools to address financial instability so they can use monetary policy, primarily interest rates, to combat inflation.

While emergency lending tools prevented other bank runs, they may not have fixed the underlying problem for some regional and midsize banks, whose long-term viability is threatened if higher rates force them to pay significantly more for deposits. 

Banks are facing losses on fixed-rate securities they acquired when rates were very low in 2021, though they don’t have to recognize losses if the investments are held to maturity. The Federal Deposit Insurance Corp. recently estimated such unrealized losses were around $515 billion at the end of March. That number would jump to well above $1 trillion if it included losses on low-yielding mortgages and other loans made when rates were much lower.

Banks’ emergency borrowing from the Fed remains high, and an index of regional bank stocks is down 19% this year, though it has rebounded from a decline of 29% in early May. Surveys show banks continue to tighten lending standards as their funding costs rise and as they face the prospect of tougher supervision and regulation. 

A credit crunch could initially help the Fed by slowing the economy and easing price pressures, but the slowdown in credit growth could easily get out of control. Raising interest rates in such a scenario could be like smacking a ketchup bottle repeatedly—nothing comes out at first, and then the whole bottle suddenly empties all over your dinner.

The conventional wisdom holds that rising interest rates are good for banks. While the value of their loans and securities declines, when rates rise, their deposits also become more valuable because banks don’t fully pass along higher rates to depositors.

This assumes that depositors are unlikely to move their money in search of a higher yield—such as to another bank or a money-market mutual fund. If depositors are mobile, “then higher rates in general start to be pretty bad for banks,” said former Fed governor Jeremy Stein.