The Fed Passes the First Test of Its Inflation Resolve

The Federal Open Market Committee (FOMC) has made its first significant test of its commitment to curb inflation by boosting the federal funds rate by 25 basis points. This move aims to show the firm determination of the Fed while maintaining confidence in the financial system amid the sudden collapse of Silicon Valley Bank (SVB) and the fallout for regional banks.

The Exceptional Two Weeks

The past two weeks have been exceptional in the banking world. During the testimony before Congress in March, Federal Reserve Chairman Jerome Powell stated that the Fed’s goal was to return inflation to its 2% target. Investors took notice and priced in a 50-basis point rate hike for the March FOMC meeting. However, two days later, as SVB failed, investors began to wonder if the Fed would pause.

The Fed’s Actions to Protect the Financial System

The FOMC meeting led to an acknowledgment that “additional policy firming may be appropriate,” but the Fed did not commit to any future course of action. Moreover, the Fed and Treasury Secretary Janet Yellen acted to protect the financial system. These actions included protecting all SVB and Signature Bank deposits and establishing a program that allowed banks to swap Treasuries and mortgage-backed securities at par values for cash.

The Change in Perception of the US Banking System

Most striking is how investors’ perceptions of the US banking system have changed overnight. The flight to quality was observed as short-dated Treasury yields fell by over 100 basis points and 10-year Treasuries by 50 basis points. Regional banks are perceived to be in a shakier environment. This is because, in 2018, Congress waived stress tests for regional banks due to a lack of systemic importance. Meanwhile, the Fed’s stress tests last year did not identify a problem that led to SVB’s failure.

Overall, the banking system was considered solid at the beginning of this year, capable of handling Fed rate hikes. But the failure of SVB showed that banks could be vulnerable to significant mismatches in the duration of their assets and liabilities in a rising interest rate environment.

Related Facts

• SVB failed due to a massive mismatch in the duration of its assets and liabilities rather than credit problems.
• SVB’s business model was unique, leaving it vulnerable to runs when its largest depositors were encouraged to pull their funds.
• The failure of SVB is reminiscent of problems encountered by savings and loans during the 1980s.

Key Takeaway

The Fed passed the first test of its inflation resolve. This move demonstrated the Fed’s determination to curb inflation while maintaining confidence in the financial system. However, the failure of SVB highlights the need for greater transparency and monitoring of banks’ assets and liabilities during rising interest rates.

Conclusion

The Fed’s move to boost the federal funds rate by 25 basis points demonstrates its resolve to curb inflation. However, the failure of SVB highlights the potential vulnerability of banks to significant mismatches in the duration of their assets and liabilities during rising interest rates. Therefore, banks must be transparent and monitored to ensure that they can survive in such an environment.