The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
Many commentators have rushed to embrace the view that Federal Reserve policy is now in a new world following the sudden failure of three US banks and the deployment of “bazooka measures” to safeguard the financial system.
But in reality, the developments represent the amplification of a longer-running predicament. They put the Fed in a deeper policy hole and make this week’s decision on US interest rates particularly important.
The failures of Silicon Valley Bank, Signature Bank and Silvergate reflected mismanagement at each of the three companies — and supervisory lapses. They forced the Fed, the Department of Justice and the Securities and Exchange Commission to launch investigations. The Fed will also now consider strengthened regulation for midsize banks. Yet this is only part of the story.
The failures were also a reflection of the mishandled shift in the country’s interest rate regime. After allowing financial conditions to be too loose for way too long, the Fed slammed on the brakes only after a protracted and damaging mischaracterisation of inflation as transitory.
It should not come as much of a surprise that this caught some institutions offside and there is now a risk of a generalised tightening of lending standards as a result. This is despite the fact that after the SVB collapse, the Fed was quick to open an attractive funding window that allows banks to get cash at par against high-quality securities that are worth less than that in the open market.
The Fed faces an intensified trilemma: how to simultaneously reduce inflation, maintain financial stability, and minimise the damage to growth and jobs. With financial stability concerns seemingly running counter to the need to tighten monetary policy to reduce high inflation, it is a situation that complicates this week’s policy decision-making.
Market pricing for this week’s monetary policy action by Fed has gone from a 70 per cent probability of a Fed 0.5 percentage point rise less than two weeks ago to favouring no increase followed by significant cuts. This is despite the re-acceleration of core inflation and another month of better than expected US job creation. The predicament highlights, yet again, the risks posed by the dominance of the financial sector.
It would not surprise me if the Fed is tempted to fudge this week, hiding again behind the veil of “data dependency”. Yet it is less easy to do this now because the approach yields two competing options: react to hot economic data by raising rates by 0.25 percentage points; or react to market data by keeping rates unchanged or cutting them.
The past few years’ decision-making process at this Fed suggests that, unfortunately, it could well opt for an intermediate solution, believing that it would keep its policy options open at a particularly volatile and uncertain time. It would leave rates unchanged and accompany this with forward policy guidance that signals that this is a “pause” rather than the end of the raising cycle.
But this would not prove an effective compromise. Instead, the trilemma would deepen as growth prospects dim due to tightening lending standards, vulnerabilities in banks and other financial companies add to financial stability risk, and inflation has become stickier.
The muddled middle would not provide the US with the monetary policy anchor it has desperately lacked and urgently needs. Instead, it would set up more policy flip-flops that fail to deliver a soft landing while amplifying unsettling financial volatility.
All this leads to two policy priorities. In the short-run, the Fed should follow the European Central Bank in clearly communicating the risks of using monetary policy for multiple and competing objectives and highlight the distinctiveness of its policy tools rather than commingle them. It should also increase rates by 0.25 percentage points (less than the ECB’s 0.5 point rise).
Over the longer term, and as I have argued in an earlier column, it is critical to address the Fed’s structural vulnerabilities including weak accountability and lack of cognitive diversity. It needs to reformulate the “new monetary framework” adopted in 2020, and consider the case for changing the 2 per cent inflation target to reflect the structural pivot from a world of insufficient aggregate demand to one of insufficient supply.
This is not easy for the Fed. Yet it is a lot better for America’s wellbeing. The alternative of continuing with the current policy approach is sure to fail to deliver low inflation, maximum employment, and financial stability. That would also increase political pressure on the Fed’s operational independence.