The Fed is forced to ‘walk and chew gum’ as inflation and banking crises erupt

Illustration of crazy and chaotic market line.

Illustration: Aida Amer/Axios

The Fed has three primary objectives: stable prices, maximum employment and financial stability. Right now it’s failing at No. 1 and may not reach No. 3.

  • However, the big dilemma he faces is that his anti-inflationary tools work at odds with those he uses to prevent a financial crisis. The central bank faces a series of tough choices as it tries to solve both problems at once.

Why is this important: Pushing ahead with further interest rate hikes and shrinking balance sheets might be the right thing to do to reduce inflation, but it could further destabilize the financial system.

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

Driving the news: The usually boring weekly release of the Fed’s balance sheet was rather different on Thursday, as it showed a whopping $153 billion granted to banks through the discount window, a key tool to ensure banks have access to cash in case of emergency.

  • This is a record, surpassing disbursements made during the 2008 financial crisis (peak: $111 billion) or the start of the pandemic in March 2020 ($51 billion).
  • On Wednesday, the Fed had also granted $143 billion to back deposit guarantees at SVB and Signature Bank, plus $12 billion granted under a new bank lending facility announced on Sunday.

Between the lines: After nearly a year of steadily shrinking a balance sheet bloated by the quantitative easing program, emergency lending has increased the Fed’s balance sheet by nearly $300 billion. in a single week.

  • Assets held by the Fed for QE — a form of monetary stimulus — are conceptually different from those held as a result of emergency bank lending, which tends to decline as crisis conditions ease.
  • At the same time, it floods the economy with liquidity, putting the Fed in a strange position: it is simultaneously removing liquidity from the financial system with one hand while adding it with the other.

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

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

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

  • Past examples show the pitfalls – including one from last year.

Rollback: During the first eight months of 2008, fissures quickly spread among the banks, which eventually turned into a global financial crisis. But inflation was also quite high, largely due to soaring energy prices.

  • The European Central Bank raised interest rates to control inflation, which turned out to be a bad decision. This put additional pressure on European banks that would unravel this fall.

Last year, the Bank of England intervened in the UK government bond market to prevent the collapse of some pension funds – while at the same time committing to aggressive tightening to drive down prices.

  • This episode went better, because the bank was able to continue monetary tightening with the moment of crisis over.

Take-out: It is more practical to have policies cut in different directions if the problem of financial stability is really limited and isolated – and not the beginning of an open crisis.

The bottom line: 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 mid-sized banks that have now been contained in full safety, or the start of something bigger.

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