Fed forced to “walk and chew gum” as inflation and banking crises flare up

Illustration of a crazy, chaotic market line.

Illustration: Aïda Amer/Axios

The Fed has three overarching goals: stable prices, maximum employment and financial stability. At the moment it is failing at number 1 and in danger of falling short at number 3.

  • The big dilemma it faces, however, is that its anti-inflation tools work in the opposite way to the ones it uses to avoid a financial crisis. The central bank faces a series of difficult choices as it tries to solve both problems simultaneously.

Why it matters: Continuing to hike interest rates and shrink the balance sheet may be the right thing to do to curb inflation, but it could further destabilize the financial system.

  • Conversely, more aggressive action to support banks may prove counterproductive in the campaign to curb inflation.
  • Fed officials tend to emphasize the use of different tools for different purposes, but in practice their effects are more difficult to disentangle. And that creates a communicative mess.

Send the news: The usually dull weekly release of the Fed’s balance sheet was rather different on Thursday, as a whopping $153 billion was provided to banks through the rebate window, a mainstay to ensure banks have access to cash in an emergency.

  • That’s a record, higher than payouts during the 2008 financial crisis (peak: $111 billion) or the start of the pandemic in March 2020 ($51 billion).
  • As of Wednesday, the Fed had also extended $143 billion to support deposit guarantees at SVB and Signature Bank, plus $12 billion in a new bank loan facility announced on Sunday.

Between the lines: After nearly a year of steady contraction from a balance sheet bloated by the quantitative easing program, bailout loans increased the Fed’s balance sheet by nearly $300 billion in a single week.

  • The assets held by the Fed for QE – a form of monetary stimulus – are conceptually different from those held as a result of emergency lending from banks, which tend to decline once the crisis situation abates.
  • At the same time, it is flooding the economy with cash, which puts the Fed in a weird position: it is simultaneously withdrawing liquidity from the financial system with one hand and adding it with the other.

What they say: “Economically there is some overlap [of] these two types of instruments, just as there is rarely a perfect separation between financial stability and monetary policy goals,” Evercore ISI’s Krishna Guha and Peter Williams said in a research note.

  • “Messy real-world policymaking needs to embrace this,” they wrote, saying that central bankers are simultaneously trying to walk and chew gum with financial stability and monetary policy.
Data: Federal Reserve;  Graphics: Axios Visuals
Data: Federal Reserve; Graphics: Axios Visuals

There’s nothing new about the tension mentioned above, which has existed for as long as central banks have been responsible for stabilizing economic conditions and their financial systems.

  • Examples from the past show the pitfalls, including one from last year.

review: In the first eight months of 2008, cracks spread rapidly among banks, eventually culminating in the global financial crisis. But inflation was also quite high, largely due to rising energy prices.

  • The European Central Bank raised interest rates to curb inflation, which turned out to be the wrong move. It put extra pressure on the European banks that would unravel that fall.

Last year, the Bank of England intervened in the UK government bond market to prevent the collapse of some pension funds – while promising aggressive tightening to depress prices.

  • That episode went better, as the bank was able to continue monetary tightening after the crisis.

The takeaway meals: It is more workable to have policy cuts in different directions when the financial stability problem is really limited and isolated – not the start of an open-ended crisis.

It comes down to: As they set policy next week, Fed officials must decide what kind of crisis they think this is — a problem limited to a handful of medium-sized banks now safely under control, or the start of something bigger.

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