The Collapse of SVB Shows Why Monetary Policy is the Wrong Tool to Fight Inflation

Recent news of the collapse of the Silicon Valley Bank, along with several more banks on the brink of downgrades, has sparked debate over the use of monetary policy in preventing financial crises. While the post-mortem of a bank failure will always reveal the bank’s own idiosyncratic mistakes, it’s clear that using traditional monetary policy tools such as interest rate hikes can have unintended consequences.

The Mistake of the Silicon Valley Bank

The Silicon Valley Bank relied excessively on uninsured deposits, primarily from the tech industry, to fund its activities. On the asset side, the bank invested heavily in Treasury bonds and Mortgage-Backed Securities. While these investments had little default risk, they were subject to interest rate risk. If the Federal Reserve were to raise interest rates, the market value of these bonds would collapse, potentially leaving the bank insolvent.

The bank’s mistake was not making risky loans or investments but relying too heavily on traditional banking activities without properly hedging against market risks.

The Danger of Interest Rate Hikes

While the Fed initially showed patience in maintaining low-interest rates, it eventually succumbed to pressure and launched a series of rate increases. However, these rapid increases in a short period had unintended consequences, causing balance sheets built during low rates to become toxic.

The Volcker experiment in the 1970s is often used as evidence that the Fed has the tools to disinflate the economy. However, the disinflation was not costless and led to two back-to-back recessions. Higher rates also caused financial crises, such as the collapse of the Savings and Loan industry and the bond markets in developing countries.

It’s important to remember that the Fed was not established to control inflation but rather to prevent financial crises by acting as a lender of last resort in times of distress. The current use of interest rate hikes to fight inflation goes against the original purpose of the Fed and can have unintended consequences.

Related Facts

• The collapse of SVB has led to calls for greater regulation and oversight of banks, particularly regarding risk management and diversification of assets.
• Unconventional monetary policy tools, such as quantitative easing, have also been criticized for distorting markets and contributing to income inequality.
• The complexity of the financial system and the interconnectedness of global markets make it difficult to predict and prevent financial crises.

Key Takeaway

The collapse of SVB demonstrates the potential dangers of relying too heavily on traditional banking activities and the need for better risk management and diversification of assets. It also highlights the shortcomings of using interest rate hikes to fight inflation and prevent financial crises. Instead, policymakers must consider a range of tools, including macroprudential regulation, fiscal policy, and unconventional monetary policy measures.

Conclusion

As the debate over monetary policy and financial regulation continues, it’s important to remember that there are no silver bullets or easy solutions. While traditional monetary policy tools such as interest rate hikes may have been effective in the past, they may not be suitable for today’s complex and interconnected financial system. Instead, policymakers must consider various options and be prepared to adapt as circumstances change.