The Federal Reserve is supposed to promote the stability of both consumer prices and the financial system. But there is sometimes a tension between these two objectives.
When the central bank wants to combat inflation, it raises benchmark interest rates. In theory, this increases the cost of credit for consumers and businesses, which leads to less spending and investment, which leads to less demand for goods and services, which leads to lower prices.
Yet hiking interest rates and tightening credit conditions can also put pressure on myriad actors within the financial sector. This is especially true in the present context. For more than a decade after the Great Recession, benchmark interest rates hovered around zero. In that time, countless business plans and investment strategies formed around the presumption of a world with indefinitely cheap credit. Faced with persistent inflation in 2021, however, the Fed put that world to death. Last year, interest rates rose more rapidly than at any time in history.
That abrupt transformation of the financial environment has led many Fed watchers to fear that the central bank’s rate hikes would “break something” in the banking system before they broke the back of inflation. In that scenario, the Fed would be forced to choose between stabilizing the financial system (by easing credit conditions) or combating inflation (by tightening those conditions).
At first glance, the collapse of Silicon Valley Bank appears to portend that very conundrum. Rising interest rates have now precipitated the second-largest bank failure in U.S. history. Yet more than a year of historically rapid rate hikes have failed to cool the economy much at all as the unemployment rate remains near historic lows, consumer spending and nonresidential investment remain strong, and job growth routinely outpaces economists’ expectations. In February, prices were 6 percent higher than they had been a year earlier with the core consumer-price index rising by 0.5 percentage points over the course of the month, a more rapid pace than expected.
Therefore, it might look as though the Fed will exhaust the financial sector’s last reservoirs of resilience long before it brings inflation down to its 2 percent target.
But this appearance may be deceiving. The Fed will likely feel compelled to pull back on rate hikes for a while as the banking system recovers from last week’s shock. But that shock itself might do more to tighten credit conditions — and thus cool spending and investment — than the Fed’s previously planned rate hikes would have done.
Why Silicon Valley Bank failed.
Before examining the SVB collapse’s implications for monetary policy, however, we need to examine the role that rising rates played in triggering the collapse itself.
The bank run at SVB had both structural and proximate causes. As Matt Levine explains, the structural cause derived from risks inherent to being the “bank of start-ups.” Typically, rising interest rates have contradictory but net-positive implications for banks: While higher rates force banks to pay more in interest to their depositors, such rates also enable banks to collect more in interest from their borrowers. Since banks often make the bulk of their money through lending, this is a favorable trade-off.
But, in recent years, Silicon Valley Bank didn’t do very much lending because core clientele — tech start-ups — were swimming in cash. During the pandemic, shut-ins drove up demand for all manner of digital businesses, while near-zero interest rates increased Wall Street’s appetite for risky ventures that promised large yields to patient backers. Equity investment flooded into Silicon Valley start-ups as a result.
Many of those start-ups parked their cash at SVB. Deposits at the bank shot up by 86 percent in 2021. As cash piled up faster than the bank could lend it, SVB invested its money in long-term Treasury bonds and 30-year fixed mortgages. But this rendered the bank profoundly vulnerable to a sustained increase in interest rates: If the interest rates on U.S. Treasuries and new mortgages shot up, then the market value of older, lower-paying government bonds and mortgage securities would fall — which is to say SVB’s assets would lose market value.
This would be okay for SVB so long as it could sit on its low-paying bonds. Holding a bond that pays 2 percent interest, when identical bonds paying 5 percent interest are available for purchase, is suboptimal. It means that you will earn less money in the coming years than you would have had you held off on buying that Treasury bond two years ago and purchased it today instead. But making less money than you could have isn’t a death sentence.
Alas, SVB had another problem. In a high-interest-rate environment, start-ups are less attractive to investors: Why lock up your savings in a risky enterprise that might deliver returns in the far future when the government is handing out substantial returns on risk-free assets? So, as rates rose, cash stopped pouring into tech start-ups. SVB’s customers started withdrawing more cash from their accounts than they put in. Which meant SVB needed to produce more cash to pay them out — which meant it had to sell its long-term bonds at a loss. And selling assets at a loss can make you look financially weak.
Which is where the proximate cause of the bank run comes in. SVB’s clientele wasn’t just peculiar for being composed of start-ups. Its biggest depositors were also unusually chummy with each other. By design, SVB served a select community of founders who attended many of the same parties, followed many of the same social-media accounts, and belonged to many of the same group chats. And this social proximity enabled anxieties about SVB to spread rapidly through its depositor base.
SVB’s investment strategy rendered it peculiarly vulnerable to interest-rate risk. But this would not have been a problem if its depositors hadn’t freaked out about that fact. Once those depositors started heading for the exits, however, SVB was forced to sell off more assets at a loss, which then inspired more of its depositors to head for the exits, which forced SVB to sell off more assets at a loss in a vicious cycle.
All of which is to say SVB’s collapse wasn’t a necessary consequence of the Fed’s rate hikes. But the Fed’s rate hikes were a necessary precondition for SVB’s collapse.
The Fed can’t fight financial stability and inflation simultaneously.
Crucially, SVB’s collapse didn’t threaten the livelihoods of just Silicon Valley’s most contemptible hypocritical libertarians or New York City’s finest bloggers. It also threatened the solvency of every other midsize bank in the country. After all, SVB wasn’t the only bank sitting on bonds that had lost market value over the past year. And if its clients took large haircuts on their deposits, then depositors at regional banks throughout the country would suddenly have a large, collective incentive to get their cash out of those banks as quickly as possible so as to store them at one of the megabanks that enjoy the government’s implicit guarantee.
For these reasons, America’s central bank and its Federal Deposit Insurance Corporation decided to make SVB’s clients whole by any means necessary. The FDIC tried to find a buyer willing to purchase SVB’s assets for enough money to fully compensate its depositors. When this (apparently) failed, it opted to levy a special assessment on federally insured banks and use the proceeds to replenish SVB depositors’ accounts.
Meanwhile, to protect other banks from suffering SVB’s fate, the Fed established a special funding program that will insulate similarly positioned institutions against the threat of bank runs. At the same time, markets started betting that the Fed would scrap its plan for a 50 basis-point hike in interest rates later this month. Goldman Sachs predicted that the central bank would back off rate hikes entirely, at least for the time being.
All this seems contrary to the Fed’s objective of combating inflation. The central bank officially believes that restoring price stability will require a reduction in nominal wages and that reducing nominal wages will (probably) require a significant increase in unemployment. After all, if jobs are abundant and unemployed workers are scarce, then firms will need to offer relatively high wages in order to retain their existing laborers or attract new ones.
Yet, on Monday, the Fed took drastic measures to avert layoffs at firms that banked with SVB, Signature Bank, and potentially other rattled financial institutions. What’s more, these actions proved insufficient to prevent U.S. banks’ stocks from plunging Monday amid ambient fears of looming bank runs.
Indeed, it looks like the SVB fiasco might inspire depositors throughout the country to simultaneously draw down from their checking accounts even if the Fed effectively backstops those deposits. Until now, sheer inertia had kept many Americans from taking cash out of their savings accounts and putting it into Treasury bonds with a 5 percent interest rate. Some were already starting to wake up to the fact that their banks no longer pay a remotely competitive interest rate. But now a spectacular bank crisis has made this reality more readily apparent.
Terrifying banks will do more to curb inflation than raising rates by half a point.
But none of this necessarily means that the Fed has just suffered a setback in its war against high prices. In fact, the opposite is arguably true. Ultimately, what matters for the inflation outlook is less the precise level of the Fed’s interest rate than overall credit conditions. SVB’s collapse might have reduced the probability of a sharp Fed hike this month. But it simultaneously made banks less inclined to offer new loans.
Regional banks are now sweating the possibility of abruptly losing depositors. Meanwhile, after witnessing a pair of bank failures, the market’s appetite for risky bonds has declined. And when banks grow more risk averse, they tighten access to credit, which reduces debt-financed investment and consumption, thereby dampening demand and, thus, prices.
Thanks to the SVB crisis, the Fed may have less room to raise rates. But it also has less need to do so. Breaking banks probably isn’t the best way to reduce inflation (raising taxes on affluent individuals or undesirable forms of consumption while promoting investment in undersupplied goods and services seems more rational). But it is one way to cool off an economy. And it’s the way we seem to be choosing.