Inflation — or turmoil?

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The Federal Reserve faces a difficult decision at its meeting that ends this afternoon: Should Fed officials raise interest rates in response to worrisome recent inflation data — and accept the risk of causing further problems for banks? Or should officials pause their rate increases — and accept the risk that inflation will remain high?

This dilemma is another reminder of the broad economic damage that banking crises cause. In today’s newsletter, I’ll first explain the Fed’s tough call and then look at one of the lessons emerging from the current banking turmoil. Above all, that turmoil is a reminder of the high costs of ineffective bank regulation, which has been a recurring problem in the U.S.

The trouble for the Fed is that there are excellent reasons for it to continue raising interest rates and excellent reasons for it to take a break.

On the one hand, the economic data in recent weeks has suggested that inflation is not falling as rapidly as analysts expected. Average consumer prices are about 6 percent higher than a year ago, and forecasters expect the figure to remain above 3 percent for most of this year. That’s higher than Fed officials and many families find comfortable. For much of the 21st century, inflation has been closer to 2 percent.

An inflation rate that remains near 4 percent for an extended period is problematic for several reasons. It cuts into buying power and gives people reason to expect that inflation may stay high for years. They will then ask their employers for higher wages, potentially causing a spiral in which companies increase their prices to pay for the raises and inflation drifts even higher. Today’s tight job market, with unemployment near its lowest level since the 1960s, adds to these risks. The economy still seems to be running hotter than is sustainable.

This situation explains why Fed officials had originally planned to continue raising their benchmark interest rate at today’s meeting — thereby slowing the economy by increasing the cost of homes, cars and other items that people buy with debt. Some Fed officials favored a quarter-point increase, which would be identical to the increase at the Fed’s meeting last month. Others preferred a half-point increase, in response to the worrisome recent inflation data.

The banking troubles of the past two weeks scrambled these plans. Why? In addition to slowing the economy, higher interest rates depress the value of many financial assets (as these charts explain). Some bank executives did a poor job planning for these asset declines, and their balance sheets suffered. When customers became worried that the banks would no longer have enough money to return their deposits, a classic bank run ensued. It led to the collapse of Silicon Valley Bank and Signature Bank, and others remain in jeopardy.

If Fed officials continue raising their benchmark rate, they risk damaging the balance sheets of more banks and causing new bank runs. That’s why a half-point increase now seems less likely. Some economists (including The Times’s Paul Krugman) have urged the Fed to avoid any additional increases for now. Many analysts expect the Fed will compromise and raise the rate by a quarter point; Jason Furman, a former Obama administration official, leans toward that approach.

The decision is unavoidably fraught. The Fed must choose between potentially exacerbating problems in the financial markets and seeming to go soft on inflation.

All of which underscores the high cost of banking crises. In most industries, a company’s collapse doesn’t cause cascading economic problems. In the financial markets, the collapse of one firm can lead to a panic that feeds on itself. Investors and clients start withdrawing their money. A recession, or even a depression, can follow.

These consequences are the reason that government officials bail out banks more frequently than other businesses. Bailouts, of course, have huge downsides: They typically use taxpayer money (or other banks’ money) to subsidize affluent bank executives who failed at their jobs. “Nobody is as privileged in the entire economy,” Anat Admati, a finance professor at Stanford University’s business school, told me.

During a crisis, bailouts can be unavoidable because of the economic risks from bank collapses. The key question, then, is how to regulate banks rigorously enough to minimize the number of necessary bailouts.

Over the past few decades, the U.S. has failed to do so. After the financial crisis of 2007-9, policymakers tightened the rules through the Dodd-Frank Act. But Congress and the Trump administration loosened oversight for midsize banks in 2018 — and Silicon Valley Bank and Signature Bank were two of the firms that stood to benefit.

As complicated as finance can be, the basic principles behind bank regulation are straightforward. Banks require special scrutiny from the government because they may receive special benefits from taxpayers during a crisis. This scrutiny includes limits on the risks that banks can take and requirements that they keep enough money in reserve to survive most foreseeable crises. “You make sure they have enough to pay,” as Admati put it.

Bank executives and investors often bristle at such rules because they reduce returns. Money held in reserve, after all, cannot be invested elsewhere and earn big profits. It also can’t go poof when hard times arrive.

It's a lose-lose situation, meaning they technically are already backstopping the banking system and trying to stop runs on the banks, OTOH if they don't remain semi-hawkish they risk an inflation pump.

A lot of people are thinking he'll do a .25% rate hike and continue backstopping the banks - more for image and keeping retail in a bearish mindset. OTOH he could, if he feels pressed enough, say that he won't hike rates this month but is looking to do so either in April or May (again - to keep the market bearish while trying to give the banks some more breathing room).

Won't know until after 2:00 PM though. Should be interesting.

You hear some politicians--probably all who call themselves "Libertarians", and a lot of Republicans--saying that we need to do away with the Federal Reserve, or "reign it in", without getting into specifics about what they mean. But, at times like the present, they go silent.

They'd have to actually know what they'd replace it with that keeps liquidity up and prevents bank runs without the Fed and without actions that dilute working class savings or incomes by way of increased inflation. It reminds me of similarly stupid things like Elizabeth Warren saying that she was 'thinking' of raising the FDIC insurance cap from $250,000 to possibly millions, to which she either knew the consequences of what that would do (back up the banks to do even more reckless investments with the account holder's money) and she was just sending a virtue signal to her constituents for votes, or - if she really didn't get that - she probably shouldn't be saying things like that off-the-cuff from the level of government that she's at.

I did hear Ron DeSantis had an anti-CBDC meeting, that was interesting and there was some other type of CBDC legislation being pushed through by Tom Emmer of Minnesota.

On a slightly different note, crypto, it sounds like there was a Lummis-Gillibrand bill that's well liked by the industry, will be interesting to see if that goes through and it will also be... emotional I guess... to watch SEC and CFTC play tug-of-war over who gets jurisdiction over crypto (and I hate to say it - Gensler keeps looking like more and more of a douche as time goes on, will even get more interesting if FTX trials bring him to testify as a hostile witness and if his involvement with SBF turns into a public scandal of it's own). Gensler wants to call all proof-of-stake items 'digital securities' and thus all of them as unregistered / illegal digital securities whereas the head of the CFTC already has openly called Ethereum a commodity.

When we came out of the pandemic, interest rates were extremely low--they were basically giving money away, to get the economy going. So, people borrowed a lot. But, with the supply chain still hobbled, prices had nowhere to go but up. Now, what to do, what to do...

Well, they decided to raise a quarter point.

For a long time, we got used to near-zero inflation, thanks to Chinese workers being willing to work in sweatshops, for very little pay, to give us most of our consumer goods.

The pandemic disrupted that arrangement.

For a while, some economists were fretting about disinflation (falling prices). Economists always have to fret about something, no matter what.