Benjamin Fanjoy/AP Photo
FDIC member Dedra Dorn (center left) speaks with individuals in line outside Silicon Valley Bank’s headquarters in Santa Clara, California, March 13, 2023.
What a difference the collapse of a large bank makes.
A week ago, Fed Chairman Jay Powell was escalating his obsession with supposedly worsening inflation. In testimony before the Senate Banking Committee last Tuesday, Powell broadly hinted that the quarter-point interest rate hike expected at the next meeting of the Federal Open Market Committee would not be enough, and that the Fed would likely return to half-point rate hikes. Financial markets promptly tanked.
But the collapse of Silicon Valley Bank changes everything.
As David Dayen has written, the cause of the collapse was the Fed’s abrupt and relentless interest rate hikes coupled with policies of deregulation that allowed banks to take ever bigger risks. So now, from an entirely unexpected quarter, the Fed is having to re-evaluate its concerns and priorities.
The immediate effect will be the use of other tools to prevent a worsening of bank balance sheets and panics. Citing systemic risks, the Fed has offered banks one-year loans so that they don’t have to cash in bonds to meet liquidity requirements. Those bonds were purchased on the assumption that low interest rates would continue. They lost value as rates rose, and cashing them in was producing losses, as it did at SVB.
But this emergency measure is far from sufficient to stabilize a banking system that is reeling from both the direct impact of the rate hikes on banks themselves and the indirect dousing effect of higher rates on speculative startups that are bank customers. The epicenter of this downward spiral was Silicon Valley.
And here is the biggest outrage. Banks are getting easy money from the Fed, while the rest of the economy suffers from Powell’s tight-money policy.
The economy may yet be spared the half-point rate hike that Powell was threatening last week, as the Fed deals with the immediate banking emergency. But the Fed still seems on course to exact more punitive rate increases.
The Fed needs to re-examine its premise that the inflation rate needs to come down all the way to 2 percent—a goal that the Fed’s own economists say cannot be achieved without inducing a deep recession.
The fact is that the real economy can do just fine with inflation at 3 or 4 percent. At two separate periods during the postwar boom, inflation rates were well above 4 percent; economic growth was excellent, businesses and homeowners got all the credit they needed, and banks did fine.
In the years of the immediate postwar recovery, from 1946 to 1951, inflation rates averaged over 5 percent. The Fed in that era was smart enough not to strangle the recovery in order to meet some artificial price target. On the contrary, with a large overhang of a war-induced public debt, the Fed deliberately kept interest rates very low so that the government would not go broke paying interest on the war debt.
And in the period between 1966 and 1972, inflation rates averaged over 4 percent. This was well before the OPEC oil price increase that set off an inflationary spiral. Much of this was the result of Lyndon Johnson’s war spending, but until OPEC the inflation was manageable and coexisted with strong economic growth.
The cause of price pressures, increasingly, is not macroeconomic overheating; it’s planetary overheating.
In the period between the early 2000s and the price increases set off by the supply chain crisis in 2022, the Fed kept interest rates very low. It did so first to protect speculative bets made by the financial system—and kept rates even lower to stimulate a recovery from the financial collapse of 2008 that all the speculation caused.
The real economy thrives on low interest rates that are needed to finance real investment—but only when loose money is combined with tight regulation, so that it doesn’t create speculative bubbles.
Despite the very low rates of the past two decades, there was little price pressure because the economy relied on so much outsourcing to low-wage countries. In fact, a research paper available on the Fed’s own website by two senior Fed research economists, titled “Who Killed the Philips Curve?” finds that inflation was low during that entire period because labor market policies and the relentless assault on unions undermined worker bargaining power and thus killed the (always imperfect) trade-off between inflation and unemployment.
The real inflation story is hidden in plain view. Powell should confer with his own research staff, or at least read the Fed’s website.
TODAY WE ARE IN a very different economy, where somewhat higher inflation rates are the new normal. But the reason is not a notable boost in worker bargaining power.
The deeper reason is the climate crisis. The Fed should build this new reality into its analysis or it will perversely cause needless recessions.
We are entering a period when water will become more scarce and expensive, which in turn will increase food prices. The necessary efforts to prevent coastal flooding from warmer oceans will require massive public projects that will incur some supply bottlenecks, bidding up some prices. New diseases related to climate change will affect supply and price, as in the case of bird flu increasing the price of eggs.
In short, the cause of price pressures, increasingly, is not macroeconomic overheating; it’s planetary overheating.
Sen. Sheldon Whitehouse (D-RI), the new chair of the Senate Budget Committee, has made recognition of the connection between the climate crisis and a new kind of inflation something of a personal crusade.
“We have all these warnings,” Whitehouse said at a February 15 hearing of his committee. “Warnings of crashes in coastal property values as rising seas and more powerful storms hit the 30-year mortgage horizon. Warnings of insurance collapse from more frequent, intense and unpredictable wildfires. A dangerous interplay between the insurance and mortgage markets hitting real estate markets across the country. Inflation from decreased agricultural yields. Massive infrastructure demand. Trouble in municipal bond markets.”
As in the period during and after World War II, needed public investment will also keep the debt ratio relatively high. The Fed will need to accommodate that reality with moderate interest rates, or it will add to the government’s fiscal stress.
In short, Powell needs to appreciate the new reality and throw out the outmoded playbook that the Fed has been using.
Will he? If he begins to revise his views, priorities, and policies, we can thank the collapse of Silicon Valley Bank. If he doesn’t, we can expect cascading crises based on the interaction of the Fed, the financial system, and the real economy.
