The Fed's new dilemma: Protect banks or fight inflation?
SYLVIE DOUGLIS, BYLINE: NPR.
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DARIAN WOODS, HOST:
This is THE INDICATOR FROM PLANET MONEY. I'm Darian Woods.
WAILIN WONG, HOST:
I'm Wailin Wong. And this morning over our morning coffee, we all had to digest some bad news on inflation. The numbers are out for February, and the consumer price index was up 6% from a year ago.
WOODS: Yeah, the prices keep rising. So, yeah, that coffee, that orange juice, that croissant - all likely more expensive. It's not great. I mean, this path down to low inflation is taking longer than a lot of people would have hoped.
WONG: And for a while it looked like, OK, this is the Fed's big job. They're just trying to get inflation down. But then this huge other thing happened in the middle of all of this.
WOODS: You might have heard of it.
WONG: Silicon Valley Bank, the country's 16th largest bank, just went kaput last week. And this is a really big job for the Fed, too, because the Fed is in charge of making sure the banking system is healthy.
WOODS: And so there's this huge dilemma on the Fed's hands. Does it keep raising interest rates and really bring down inflation or does it take a pause, take a breather and make sure that the financial system - which, by the way, is its other goal - make sure that the financial system is safe?
WONG: It's a big problem. I am happy not to have this problem, but I am very happy to explain to you why it's a problem. Today on the show, we go through the Fed's dilemma and we see what a pause in interest rates would mean for both the banking system and for inflation.
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WONG: The Federal Reserve had a very dramatic weekend. On Sunday, in response to the SVB meltdown, it said it was freeing up additional money for banks that might need help safeguarding their deposits. The Fed wanted to prevent any more bank runs like the kind that brought down SVB.
WOODS: This is one of the Fed's primary jobs. It is to make sure that the country's banks are healthy, and it's this responsibility that could lead the Fed to pause its rate hikes because when interest rates go up, the value of investments like U.S. Treasury bonds goes down. And banks hold a lot of these kind of bonds.
WONG: Yiming Ma is an economist at Columbia Business School who studies monetary policy and financial stability. She says it's usually no big deal for banks to have all these bonds and other investments as long as they're just hanging onto them.
YIMING MA: It's only when you have to sell these securities that, you know, that market price that is now lower because of higher interest rates starts to matter.
WOODS: And it also matters whether the banks are well-run in the sense that they've got hedging strategies in place to protect against the impact of higher interest rates. Like, if interest rates go up, they're protected. And SVB had way more of its money in these bonds and similar investments than other banks. It wasn't hedged properly.
WONG: But Yiming says there is a chance that SVB's problems could be playing out maybe on a smaller or less severe scale at other banks, and these banks could be in greater danger as interest rates go higher.
MA: I think that's sort of where the important judgment comes in. If SVB got into this trouble, other banks sooner or later will run into the same trouble. So, you know, then it's going to be really important to not raise rates really aggressively.
WOODS: So a pause in rate hikes would take the pressure off banks with a lot of these bonds. They'd have time to manage their balance sheets without worrying that those investments will keep losing value.
WONG: Yiming says a pause could also help some banks on the deposit side of their balance sheets because higher rates usually lead to more deposits flowing out of banks.
WOODS: And that might sound counterintuitive, but when the Fed hikes interest rates, deposit rates on savings accounts don't go up as much as interest rates on other kinds of investments. So depositors take their money and go in search of higher returns elsewhere.
WONG: One common destination is a mutual fund, which is when you work with a professional money manager who pools your money with other people's money and invests it all together. If you've heard of money market funds, that's a type of mutual fund.
MA: It has been pretty robustly shown that when interest rates go up, you don't like to save your money in the bank account anymore because, you know, the money market fund, the mutual fund are going to give you a much higher rate than the bank account does.
WOODS: And so if the Fed is worried about a lot of deposits flowing out of banks right now, it could leave rates where they are.
WONG: And some voices in the finance world are calling for a pause. This chorus includes Sheila Bair, who was at the head of the FDIC during the 2008 financial crisis. It also includes analysts at Goldman Sachs. They said that given the stress in the banking system, they don't think the Fed will hike rates at the next meeting.
WOODS: Carolin Pflueger is an economist at the University of Chicago's Harris School of Public Policy. Carolin researches monetary policy, inflation and financial markets, and she says whether a pause in rate hikes is warranted depends on how bad you think the SVB fallout will be on the broader economy.
CAROLIN PFLUEGER: The thinking there could very well be that this is a bad shock, and this bad shock, in a way, acts very similarly to a rate hike already.
WONG: Carolin says, think about it this way. Let's say jitters in the banking system make it harder for businesses and consumers to access credit. Those businesses invest less, and consumers spend less. The economy slows down, inflation falls.
PFLUEGER: And it would be very natural to think, OK, if this is already happening, we don't need to hike rates in addition to kind of double down on this effect. That's a - perfectly sound logic if you think that this shock is large enough.
WOODS: OK. So that's a couple of reasons for keeping rates steady, but this approach also has a lot of risks. I mean, for one thing, inflation - it could keep climbing or just stay stuck way higher than the Fed's 2% target.
WONG: Just last week, before the SVB collapse, Fed Chair Jerome Powell told Congress that they'd made some progress on inflation but not enough.
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JEROME POWELL: My colleagues and I are acutely aware that high inflation is causing significant hardship, and we're strongly committed to returning inflation to our 2% goal.
WOODS: So pausing the interest rate hikes, which is the Fed's main tool for fighting inflation, that could lead to even more pain for people who are vulnerable to rising prices.
WONG: Economist Yiming Ma says another risk is that the Fed could lose control of inflation expectations and damage its own credibility.
MA: If the Fed's been saying for the past couple of years - well, we're really committed to fighting inflation; we're you're going to bring price levels down - and suddenly, you know, they stop doing it, and they lose control over this variable they've been claiming they have control over, then going forward, you know, next time we have inflation or next time they're going to say anything, you know, it's going to be a question whether they will be convincing and effective anymore.
WOODS: Even before the SVB crisis, the Fed was already facing this really tough job of trying to engineer a soft landing for the economy - you know, raising rates just enough to cool down the economy and bring down prices without causing too much pain in the form of lost jobs or a sudden sharp decrease in lending.
WONG: The collapse of a major bank like SVB makes this job even harder because it means the Fed has to decide which of its big responsibilities to prioritize - price stability, employment or the health of the banking system.
PFLUEGER: The Fed's job is to stabilize inflation and unemployment, while also ensuring financial stability. And exactly, you know, what the weights are on these different things is not written down as a number.
WOODS: So it might seem like the Fed's current dilemma pits banks against ordinary people, like a pause on interest rates could protect banks but send inflation higher while continuing to raise rates could destabilize banks but give consumers some price relief.
WONG: But it's not that simple. A well-functioning banking system is good not just for the banks themselves, but also for the individual consumers who save and borrow money.
MA: If you think about - you know, is the average consumer happy with more inflation, less inflation, more risk in the financial sector, less risk? - I think that's really the tricky question to ask.
WOODS: And that's the kind of question that Fed members will be debating next week when they make a decision on interest rates. Before the collapse of SVB, Jerome Powell had signaled that the Fed was prepared to move more aggressively on rates if the data warranted it. Now, it's not certain whether rates will go up at all.
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WONG: This episode of THE INDICATOR was produced by Brittany Cronin and engineered by Katherine Silva. It was fact-checked by Sierra Juarez. Viet Le is our senior producer. Kate Concannon edits the show. And THE INDICATOR is production of NPR.
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