Financial Turmoil Could End Up Doing Rate-Setters’ Job for Them

Central bankers have long maintained that they can draw a line between their actions to stabilize the banking system and those aimed to quell inflation. Yet, recent developments cast doubt on this claim. For example, the US Federal Reserve raised interest rates by 0.25 percentage points last Wednesday, even though three mid-sized US lenders had collapsed in the preceding weeks. Turmoil in the financial system affects monetary policy, and central banks must adapt. Let’s take a closer look.

The Fed Responds to Financial Instability

The Federal Reserve pumped nearly $300 billion into the US banking system in the last week of August after unveiling a new facility called the Bank Term Funding Program. Lenders can now exchange their US Treasuries for cheaper central bank loans. This program addresses problems plaguing the now-defunct Silicon Valley Bank (SVB) because of poor risk management. SVB made an ill-advised bet on long-dated US government bonds that lost significant value over the past year. However, the sharp decline in bond prices directly results from the Federal Reserve’s actions.

The Impact on Monetary Policy

Over the past year, the Fed’s focus on curbing inflation has led to a rise in interest rates and the runoff of over $400 billion of US debt from its balance sheet as bonds matured and were not replaced. This followed a period of massive balance sheet expansion under the quantitative easing program, which aimed to support markets and the economy by purchasing bonds to counter the impact of the Covid-19 pandemic. Although the Fed bought $800 billion worth of bonds between March 2020 and March 2021, the balance sheet is expected to expand further in the coming weeks. The reversal from contraction to expansion fuels the sense that we live through an era of “handbrake-turn” central banking.

The Role of Global Markets

In a world of high debts, global markets must function as a massive refinancing system, where capital capacities, such as balance sheets and liquidity, are crucial. The renewed expansion of the Fed balance sheet merely reflects this need. Yet, it is not guaranteed that prices will spiral out of control. However, the late economist Milton Friedman argued that inflation is always and everywhere a monetary phenomenon; the money created by central banks represents only a tiny portion of the overall supply. In the United Kingdom, for instance, the reserves, notes, and coins linked to the Bank of England account for just under 20% of the total supply. The remaining balance comprises deposits held at private financial institutions, which also drives credit creation.

The Future of Tightening and Turmoil

Tightening lending standards and lower liquidity levels are already affecting banks on both sides of the Atlantic. Powell acknowledges that more tightening is inevitable, not just through rate hikes but also due to banking turmoil, which could have an effect equivalent to a walk. However, nobody knows how intense this turmoil-related “hike” will be. Claudia Sahm, a former Fed economist and founder of the Stay at Home macro blog, points out that “nobody put bank failures in the toolkit.”

Related Facts

• The Bank Term Funding Program replaces the Money Market Mutual Fund Liquidity Facility launched in 2020 to stabilize financial markets affected by the Covid-19 pandemic.
• The collapse of Silicon Valley Bank pushed the Federal Reserve and other central banks to reassess their approach to the risks of the banking system.
• Since the financial crisis of 2008, banks have tried to become more resilient to shocks by increasing their capitalization and reducing their leverage ratios.

Key Takeaway

Central banks have insisted that they can separate actions to fix the banking system from those to control inflation, but recent events suggest otherwise. Financial instability is beginning to impact monetary policy, and central banks must adapt. Although nobody knows precisely how vigorous this turmoil-related “hike” will be, it is evident that financial turmoil could end up doing a rate-setter job for them.

Conclusion

The recent developments highlight the need for central banks to stay vigilant in balancing the risks of inflation and financial instability. Despite recent bank collapses, the Federal Reserve’s decision to raise interest rates underscores its commitment to maintaining monetary stability. However, the response to the Silicon Valley Bank collapse with the Bank Term Funding Program shows the pressing need for central banks to have tools to address the risks posed by financial instability. Ultimately, the question is whether central banks can keep their promise to maintain a neat dividing line between actions taken to quell inflation and those to fix turmoil in the banking system.