Teao suppress inflation, the saying goes, central bankers should tighten monetary policy until something breaks. Over the past year it’s been easy to dismiss this cliché. From March 2022, US’s Federal Reserve to hike rates fastest clip since the 1980s. Even when the markets fell, the world’s financial system remained free of wreckage. When British pension funds faltered in September, the Bank of England swiftly helped them recover. Most notable fallis that ftxA discredited former crypto exchange—was well outside the mainstream and, regulators say, due to fraud rather than the Fed.
Now something is broken. Silicon Valley Bank failure (svb), a mid-tier US lender that went bust on March 10, has sent shock waves through financial markets. Most noticeable has been the turmoil in shares of other banks, which could have investors worried about similar vulnerabilities. NasdaqThe index of bank stocks fell by a quarter over the course of a week, erasing all of its gains over the past 25 years. Shares of regional lenders were hit hard. As soon as this article was published, a backlash had begun. Financial markets, however, have entered a new phase: that of the Fed’s tightening cycle.
One characteristic of this phase is that the markets are suddenly working with the Fed, not against it. For more than a year, central bank officials have been repeating the same message: that inflation is proving more stubborn than expected, which means interest rates will need to rise more than previously thought. This message was confirmed by data released on March 14 that showed that underlying consumer prices once again rose faster than expected.
Policymakers seek to tighten financial conditions – such as lending standards, interest costs or money-market liquidity – to reduce aggregate demand and thus reduce price growth. The markets have been pulling in the other direction since October. A gauge of financial conditions compiled by data provider, Bloomberg, has shown them to be continuing to loosen. Over the past week, all this easing has been reversed, even accounting for the rebound in bank stocks. svbThe collapse of the U.S. has jolted the markets into doing the work of the Fed.
That doesn’t mean investors have given up fighting the Fed. They are still betting that it will start cutting rates soon, though officials have given no indication of that. The battleground, however, has shifted. Earlier this year, expectations for a rate cut were fueled by expectations that inflation would fall faster than the Fed expected. Now they reflect fear. The two-year Treasury yield declined 0.61 percentage points on March 13, the biggest one-day decline in more than 40 years. Given that some banks have failed, investors are betting that the Fed will cut rates not because the inflation monster has been contained, but to avoid breaking anything else.
Taken in conjunction with the reaction in other markets, this suggests a degree of cognitive dissonance. After the initial dive, the broad stock market indices made a strong comeback. SAndP The 500 index of large US firms is level with its position at the beginning of the year. The dollar, which strengthens in a crisis as investors flock to safety, weakened slightly. On the one hand, investors think the Fed should fear failure of other institutions to start cutting rates. On the other hand, they themselves are not so afraid of the consequences of such failure as to reflect it in asset prices.
Behind this contradiction is thought to be a tension between the Fed’s inflation target and its duty to protect financial stability. failure of svb, which was rooted in losses from fixed-rate bonds (whose value fell as rates rose), looks like evidence for this. Since even the fight against inflation becomes insignificant next to the stability of the banking system, the argument goes, the Fed cannot afford to raise rates any further. This reduces recession risk, boosts stocks and reduces the need for a haven asset like the dollar.
do not be so sure. next svbIn the fall of , the Fed has promised to backstop other banks. Its backing – lending against securities worth two-thirds of the loan value – should prevent any remotely solvent institution from hitting the bottom of interest rates. Along with this generosity, there is an uncomfortable truth. To get inflation out of the economy, the Fed needs to harass lenders, make loans costlier and businesses risk-averse. like allowing reckless banks svb To fail is not a tragic accident. It’s part of the Fed’s job.