The Federal Reserve meets this week to decide whether to raise interest rates further after six rate increases in the last 10 months. With inflation still unacceptably high, a rate increase should be warranted. But the higher rates are contributing to bank failures so maybe rates shouldn’t be raised. This dilemma and the resulting economic quagmire are completely the fault of the Fed.
In early 2021, it was obvious to any objective analyst that inflationary pressures were building in the economy. Historically, the Fed would stay in front of inflation to make sure the problem doesn’t get out of hand. The goal is to keep inflation in the 2% to 3% range.
That means the monthly Consumer Price Index change should be in the 0.1% to 0.2% range. That results in an annual CPI of about 2%. But in January 2021, the CPI increased by 0.3%, then 0.4% in February, 0.6% in March and 0.8% in April. Inflationary pressures were clearly building, especially considering the Federal government’s deficit spending.
In 2020, the government deficit was $3 trillion. In 2021 with the Biden Administration was planning to deficit spend another $3 trillion, which would add significantly to the inflation problem. Yet the Fed took a shockingly irresponsible position saying the inflation was temporary. They used the word transitory.
Except perhaps during a time of war or extreme famine, inflation has never been transitory. Yet all through 2021, the Fed continued their expansionary bond buying program, which increases the money supply and tends to stimulate the economy; an economy that was already over-stimulated and growing at a 6% rate.
The Fed continued this expansionary policy into 2022. Finally, in March of 2022, the bond-buying program was completely stopped, and interest rates were raised by 25 basis points. That small rate increase did little to slow inflation. By June, inflation reached 9.1% as measured by the CPI.
Nearly all of the inflation was due to the excess government spending and to the Fed’s shockingly irresponsible Monetary Policy. Had the Fed started to raise interest rates a year earlier, in March 2021, the rate increases would have been smaller and more gradual. The inflation rate would likely have been about half of what it is today.
Indeed, the Fed must take full responsibility for today’s inflation problem. The Fed is also, at least partially, responsible for the bank failures that we see today.
Although the specifics of why each bank failed are yet to be fully determined, the rapidly rising interest rates probably paid a large role.
In June of 2022, when the annual CPI reached 9.1%, the Fed finally realized that price stability was indeed one of their goals.
After ignoring inflation for a year and a half, shortly after a June meeting Powell said, “Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone.”
Over the next 10 months interest rates were raised from near zero to 4.75%. That’s the most rapid increase since 1980. Interest rates on Treasury bonds increased from the 1 ½% range to more than 4%. That contributed to the bank failures.
Silicon Valley Bank, which was the second larges bank failure in history, had severe liquidity problems. Since the US operates on a fractional banking system, most of the deposits placed into banks are not actually held by the bank. Instead banks make loans with some of the funds and they make investments often by purchasing long term government bonds.
SVB had a large portfolio of low interest, long term government bonds, believing that when interest rates did finally go up, the increase would be gradual so they had time to adjust their bond portfolio.
When their biggest depositors experienced decreasing revenue and therefore had to put large amounts out of their checking accounts, SVB had to sell assets to cover those withdrawals.
Because interest rates had tripled, they were forced to sell their low yield bonds at a large discount. Suddenly their bond assets fell in value so that their deposit liability exceeded the value of their assets. The bank failed.
Had the Fed acted responsibly in 2021, inflation would be much lower and the banks would not be failing. Instead, the Fed has created the current economic quagmire.
Michael Busler is a public policy analyst and a professor of finance at Stockton University in Galloway, New Jersey, where he teaches undergraduate and graduate courses in finance and economics. He has written op-ed columns in major newspapers for more than 35 years.
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