Sometimes even a blind squirrel finds a nut!
That’s the phrase that comes to mind when I think about this banking crisis and the impact it may have on the economy and the stock market.
Why? Because the Federal Reserve has been trying for more than a year to convince investors, consumers and businesses that it’s serious about slowing the economy and taming inflation with higher interest rates.
But it hasn’t worked. Consider…
- Consumers have kept shopping. Consumer spending saw its sharpest rise in nearly two years in January, according to the Bureau of Economic Analysis.
- Businesses have kept hiring. They added more than 300,000 new jobs in February, and the unemployment rate remains near a decades-low level.
- Investors have kept bidding up stocks. True, the market has had its ups and downs in recent months. But it seems to have put in a bottom in mid-October and has gradually risen – in fits and starts – more than 10% since then.
I covered back in early February how the Fed had lost control of the stock market.
As a result of these failures, Chairman Jerome Powell and his colleagues were at their wit’s end earlier this year. That’s why just before Silicon Valley Bank and Signature Bank failed, Powell started sounding even more hawkish.
It seemed desperate… as if the Fed’s blunt instrument – short-term interest rates – just wasn’t up to the task of cooling the hot economy.
But little did the Fed realize that something was brewing in bank balance sheets that just might accomplish the central bank’s goal of slowing the economy…
Remember the global financial crisis of 2007-2008? It was caused by banks dabbling in toxic assets like subprime mortgage loans – and derivative assets linked to them (such as credit default swaps). Those assets are like uranium; they bring destruction and decay to everything in sight.
After that crisis, the Fed and other regulators dramatically altered the rules on the types (and quality) of capital that banks have to hold in reserve.
And in recent years banks have been much healthier, better capitalized and seemingly less vulnerable to a similar crisis.
In fact, many banks – like the two that just failed – had invested in the safest assets available: long-dated U.S. Treasury securities, as well as mortgage-backed securities guaranteed by quasi-federal enterprises like Fannie Mae. All very safe.
So there was little credit risk with the assets that banks were holding. The problem this time around was serious interest rate risk. When interest rates rise, the value of long-dated assets falls because investors can get higher yields elsewhere.
Sure, if you hold these bonds to maturity, you’re going to get your money back. But depositors at these regional banks wanted their money now, not in 10 years.
That’s called an asset-liability mismatch. It caused the runs on those banks and drove them under. And nobody – at the Fed or anywhere else – seemed to see it coming.
Funnily enough, the consequences of those bank failures – and the threats to other banks – may have just the impact on the economy and the market that the Fed was seeking all along.
Take a look at the chart below, which tracks financial conditions in the U.S.
When financial conditions like risk-taking and credit availability worsen, the economy cools. And suddenly they’re worsening rapidly, exactly as the Fed wanted.
So a big congratulations to Powell and company. They finally did it, even if it had nothing to do with their strategy.
Your Questions: Answered
Speaking of the Fed, a reader sent in a few questions regarding my article about the Fed getting more hawkish.
Elisabeth M. asked whether the Fed has other options for lowering inflation besides raising interest rates. She also asked, “When is the interest rate tool used to its full extent?”
Yes, the Fed has many levers it can use to try to bring down inflation. In addition to raising its target short-term interest rate, it can increase the level of reserves that commercial banks must hold. That would decrease the amount of money these banks could lend.
The Fed can also sell off some of the massive pile of bonds it owns – about $8.3 trillion worth or so. When it sells an asset, it takes in cash and puts it to bed, decreasing the amount of money in the economy and slowing growth.
And the Fed always has so-called forward guidance. That’s a fancy term for the Fed talking tough about what it’s going to do. Investors and consumers used to listen to this and fear it, but it seems to be less effective these days.
Finally, how high can the Fed raise interest rates? In theory, the sky is the limit.
Former Fed Chairman Paul Volcker infamously raised the Fed’s target rate to 20% in the early 1980s to get soaring inflation under control. That pushed other important rates up – the average 30-year fixed mortgage rate rose above 16% in 1981 – and drove the economy into recession.
Let’s hope we don’t have to go there again.