Taking Stock: Squaring the circle has become still harder for the Fed

The Fed’s quandary became more difficult last week. The bank crisis shows no sign of easing, with PacWest, Western Alliance and First Horizon amongst the many small and mid-sized banks now under the spotlight.

Meanwhile, Friday’s strong labour market data will support core inflation.
The two problems call for opposite monetary policies from the Fed. The Fed looks set to continue with the focus on inflation, with all the risks for macro-economic stability and growth that implies.

Bank crisis calls for Fed easing

The bank crisis cries out for lower interest rates, a pause on quantitative tightening and perhaps substantial purchases by the Fed of short-term securities in order to bring down yields across the curve.

Would that contradict Walter Bagehot’s dictum that is today treated as gospel by central bankers? Writing in the nineteenth century, the British economist wrote that, in order to end a bank panic, central banks should lend freely to the banking system, albeit at a high-interest rate and only against good collateral.

Absolutely. Buying securities in the market, and perverting the prices of securities in the process, is completely contrary to the spirit of Bagehot. But that Rubicon has long ago been crossed by central banks, when they introduced quantitative easing and other asset purchase programs.

But, crucially, no one can doubt the quality of the securities that banks bought with the wave of deposits during the Covid years. They are sitting on U.S. Treasuries, perhaps the highest quality collateral there is.

Indeed, as many have noted, on bank a historical cost basis of accounting, the banks are sound. Rather, the crisis is based on a notion of bank insolvency arising from mark-to-market accounting – which should be irrelevant, given that the securities were purchased to hold to maturity.

The losses on Treasury paper reported under the mark-to-market method only matter if depositors and investors believe they do and panic. Unfortunately for the banks, both depositors and shareholders have adopted that approach.

Bloomberg’s Matt Levine, in a very engaging commentary,* recently wrote that depositors are not pacified by assurances that the securities will be held to maturity and will be profitable over time.

The withdrawal of deposits, by those who read of mark-to-market insolvency banks’ balance sheets, becomes justified in its own way, when their action then triggers insolvency on a historical cost accounting basis. This happens when banks have to sell securities and crystalise losses, in order to raise funds.

Worryingly, potential investors in new bank equity -who could otherwise help shore up those losses made on securities- are also made queasy by mark-to-market losses.

They are intimidated by the speed and scale of the deposit flight. This appears to be lesson from First Republic, who tried and failed to issue fresh equity, in a convoluted deal with Goldman Sachs.

Depositors and investors both appear to want safer banks, with balance sheets that can absorb temporary mark-to-market losses with mountains of loss-absorbing equity capital. The price, though, for having a banking sector where every bank has a balance sheet like JP Morgan, may well be slower growth as capital is rationed to riskier venturers.

The ‘pivot’ has been delayed

If ending the bank crisis calls for looser monetary policy, surprisingly strong labour market data on Friday suggests that interest rates may have to remain at the new 5%-5.25% target range for some time to come. The ‘pivot’ has been delayed. Indeed, a further hike in the current cycle cannot be ruled out if the Fed is to prioritise the war on inflation. Viewed through this lens, a reduction in bank lending due to the bank crisis would be helpful.

Numerous labour market surveys have shown some weakness emerging recently.

But Friday’s data releases went against this trend, with April’s non-farm payrolls at 253,000 -well up on the 180,000 expected. Unemployment fell to just 3.4%, against an expectation of 3.6%, and wage growth continued to rise at 4.4% year-on-year.

This is somewhat surprising for a decelerating economy. The U.S. economy recorded 1.1% annualised GDP growth in the first quarter.

It must also be immensely frustrating for Fed chair Jay Powell and the rest of the policy making committee at the Fed, as they try to avoid recession and nurse the bank sector through its crisis.


In March, Jay Powell assured the markets that the bank crisis will not become systemic. This now looks hollow. Jittery depositors and equity investors, short sellers and banks’ own maturity mismatching -based on the assumption that any Fed rate hiking would be brief- have seen to that.

The Fed has the tools with which to address the problem, should it choose. It must be tempting to do. It will certainly come under increasing political pressure to ease monetary policy.

But to do so would invite scepticism over its anti-inflation credentials, potentially lifting long term inflation expectations. As we wrote last week, it would raise the prospect of the Fed repeating the Paul Volcker error of cutting rates too early, only have to raise them again later.

The Fed’s bias is currently to focus on inflation. Events over the coming weeks may change that. If it does, it is less likely to be because it feels it has won the war on inflation, and more likely to be because of fear of broad macroeconomic instability arising from the bank crisis.

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  1. No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision. Charts used are for illustrative purposes only and should not be used to form the basis of any investment decision. 
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*Matt Levine. ‘Money Stuff: Nobody trusts the banks now’, Bloomberg May 4, 2023

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