For the past year, the Federal Reserve has raised short-term interest rates at the fastest pace since the early 1980s in an attempt to curb the hottest inflation since the early 1980s. But in its zeal to tame inflation, the Fed has been seemingly indifferent to all the ways that sudden sharp shifts in the economic wind can have unintended and potentially severe side effects.
That simple truth, which should have been obvious, made itself more than manifest last week when one of the larger financial institutions in the United States collapsed suddenly. Silicon Valley Bank as of March 1 was worth nearly $17 billion and had close to $200 billion in customer deposits. Its customers were often venture capital firms and the companies that they funded, making the bank a powerful player in a lucrative niche. Then, almost without prelude or warning, those venture firms panicked when the bank announced that it was selling some of its Treasury bonds at a loss and they advised the firms they were backing to pull their money. Within two days, $40 billion was yanked, the stock plummeted and federal and state regulators stepped in and took over. Two days after that, regulators seized New York-based Signature Bank, which had over $100 billion in deposits.
Those two were the biggest bank failures since the 2008-209 financial crisis, and the second and third largest bank collapses in U.S. history. And they happened almost overnight, with little build-up and few warning signs. Even the 2008 crisis, as severe as it was, was presaged by abundant signs that something was amiss in the financial sector. These two bank runs, followed by general panic among depositors and investors that all mid-sized banks were in serious trouble, were more like a sudden car-crash: everything appeared relatively smooth until it absolutely wasn’t. And the culprit in this case was the very institution whose mission is to prevent bank runs and systemic collapse: the Federal Reserve.
The collapse of the two banks created an immediate panic in financial markets, with shares of a nearly a dozen regional banks plunging on fears that customers would flee to the safer havens of the large money center banks such as J.P. Morgan Chase and Bank of America. Recognizing that bank runs and panics tend to spiral rapidly and uncontrollably, the Treasury Department and the Fed acted swiftly to guarantee that even as the banks themselves might be dissolved and shareholders wiped out, actual depositors would have full access to the funds and lose nothing.
All of this happened so fast that it was difficult even for informed participants to keep up with the developments, let alone come up with a clear sense of what went wrong. There is and will be considerable (and rather arcane) debate about whether the Treasury bonds that Silicon Valley held were sufficient to cover their short-term capital needs during a multi-month period where many of the longer-dated bonds (over 10 years) were losing value in the face of the Fed raising interest rates.
What is clear is that in the wake of the last great financial crisis, banks were required to hold more capital and reduce their risk. Silicon Valley Bank did just that in holding what are considered nearly risk-free assets, U.S. government bonds. The arcane part, albeit crucial, is that there is a significant difference in holding 2-year bonds versus 30-year bonds when interest rates are rising quickly. The longer the duration of a bond, the more its price drops when rates are rising. Because Silicon Valley Bank had more of its holdings in those long-dated bonds, it started suffering paper losses as those bonds declined in value. And because it was not so large that it had been classified as systemically dangerous like banks with over $250 billion in assets, it did not face as stringent capital and regulatory requirements as, say, Chase. When it sold a tranche of those bonds at a loss to cover customer withdrawals, the entire VC industry in California and elsewhere got spooked, told their clients to pull their funds, and voila, a bank run.
It may well be true that the management of Silicon Valley and Signature failed in their risk controls. It is undeniably true that the assets they held, U.S. government bonds, were about as vanilla as possible. In fact, the Federal Reserve and other banking regulators had made a point since the 2008-2009 financial crisis that banks that held a significant reserve of U.S. government bonds were to be viewed more favorably and as better inoculated against possible problems. That is precisely what Silicon Valley Bank did, and that is precisely why it imploded.
Which brings us to the real cause of what happened: a Fed that has been so focused on curbing inflation that it has essentially ignored the risks of its policy of raising rates more quickly than at any point in history. It has acted as if inflation is such a threat to financial stability that it lost sight of the fact that fighting inflation can, if pursued in too draconian a fashion, can itself be a threat to financial stability.
The Fed is a technocratic agency. It takes its mandates of price stability and the guarding the health of the financial system seriously, and its mandarins have been utterly crucial in times of crises, especially in 2008-2009 and in March of 2020. But the flip side is a tendency to become detached from the real-world implications of their decisions, and the past year of aggressive rate hikes have gone from a legitimate (albeit debatable) response to higher-than-expected inflation to a zealous crusade to tame higher-wages, a tight labor market and robust consumer spending in the belief that sometimes, you have to harm the economy to help it. Short-term pain for long-term gain.
That includes a seeming indifference to the secondary effects of inflation fighting. Fed officials have spoken of a labor market that is too tight “to an unhealthy level.” In the abstract, a tight labor market might be a negative for inflation given that it leads employer to pay higher wages in order to attract scarce workers, but in the real world, a tight market means that more people are employed and getting paid more. Treating that as a negative will likely enrage a substantial portion of the actual humans who comprise the economy and that in turn will eventually undermine the credibility that the Fed needs to do its job.
Even more troubling is the failure to respect the structural risks of raising interest rates so aggressively. Yes, runaway inflation at points in the past, such as Weimar Germany in the 1920s and multiple Latin American and African nations in the last decade of the 20th century, can be perilous to societal stability. But does 6% inflation for a year after a global pandemic pose a danger sufficient to push the financial system to the brink and punish banks for not adjusting quickly enough to sharply higher rates?
And the Fed can’t claim ignorance here. The balance sheets of Silicon Valley Bank and others were hardly secret, and any credible regulator could have noticed months ago that the composition of the holdings in the face of rapidly rising rates was a potential problem. No one flagged that, and while the management of multiple banks might indeed have been sloppy, careless, venal and even downright incompetent, none of that excuses the Fed, with its hundreds and hundreds of highly trained economists and a culture steeped in gaming out risk scenarios, from its carelessness here.
It is unclear yet whether this particular own-goal is a one-off or the start of a crisis. Either way, it was an entirely preventable one, and the result of reckless policy. The best the Fed can do now is pause and re-assess its current inflation fighting path. Otherwise, it may succeed in taming inflation but only at the cost of ravaging an otherwise stable and sound economy.
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