Fed can’t abandon inflation fight despite bank turmoil

Catherine Rampell

The recent collapse of Silicon Valley Bank was partly the result of rising interest rates. But that doesn’t mean the lesson is to stop raising rates, as some are now calling for. Inflation is still much too high to abandon the fight.

At least part of what went wrong at SVB is that the bank invested too much in longterm Treasury and mortgage bonds. These are normally supersafe investments. But when interest rates rise, they lose their value temporarily. At SVB, that situation scared depositors, who pulled their money out en masse, leading to a classic “It’s a Wonderful Life”-style run on the bank.

Critics (particularly progressive Democrats) say this demonstrates that the Federal Reserve has raised rates so sharply in the past year that something was bound to break. I agree to an extent: If the Fed had begun addressing inflation earlier — initiating rate hikes in, say, fall 2021, rather than March 2022 — more gradual rate hikes would have meant less of a chance of a sudden shock to the system.

And maybe if the Fed hadn’t kept rates at zero for as long as it did, we might have seen less frothy activity (in tech and elsewhere) and less reckless risk-taking.

But that analysis lets SVB off the hook. SVB should have recognized that rates were going to go up eventually and should have hedged against that very predictable risk to its long-term holdings — known as “maturity risk.” It didn’t.

“This is not rocket science,” says economist Kermit Schoenholtz, who taught business school students for over a decade at New York University. “You teach why banks try to limit maturity risk within the first few weeks of any introductory money and banking class.”

Likewise, bank supervisors — including those at the Fed — should have been specifically looking for banks that were getting this calculation wrong. The issue was hiding in plain sight: In its year-end financial report, SVB announced that its interest-rate hedges on more than $14 billion of securities had been terminated or allowed to expire throughout 2022. The fact that (almost) no one seems to have noticed this ticking time bomb suggests that at least some regulators were asleep at the switch.

Meanwhile, the reason the Fed has been raising interest rates in the first place remains: Inflation is still too high. Data released Tuesday showed that price growth is not as severe as it was last year, but at 6%, it’s still multiple times larger than the Fed’s target inflation level (2%).

As we’ve already seen, getting the pace and size of interest rate hikes right is really hard. Move too fast, and the Fed could trigger a recession and widespread layoffs — and potentially a banking crisis. But move too slowly, and inflation can become more self-reinforcing and harder to stamp out.

In sum: Whatever central bankers do to address one problem will potentially cause or aggravate another.

Right now, investors seem to be betting that the Fed will err on the side of calming the financial system rather than aggressively tackling inflation. Just last week, many forecasters had been betting the Fed would step up interest rate hikes at its next meeting; now, analysts at Goldman Sachs and Barclays predict the Fed won’t raise rates at all when it convenes next week. Some analysts are even calling for an imminent rate cut.

Slowing down or (temporarily) pausing rate hikes might be appropriate while regulators sort out the collateral damage from SVB. As Schoenholtz put it: When you’re driving along a treacherous cliff through the fog, you probably want to drive slowly.

But, he adds, that doesn’t mean your destination changes.

The Fed still needs to break the back of inflation. How does it do this without, you know, accidentally breaking the financial system, too? For one, it can step up oversight of the banking sector. This will almost certainly require help from Congress, which had rolled back financial regulation during the Trump era, as well as from other supervisory agencies.

Fiscal policymakers can also help take pressure off the Fed through tariff repeal, fixing bottlenecks in the immigration system, and other standard supply-side measures. At the very least, they can stop making the Fed’s job harder; right now they’re stimulating the economy through state-level tax cuts and federal student-debt payment pauses, and meanwhile they’re driving up construction costs through pointless protectionism. On the margin, these kinds of measures put upward pressure on prices, and thereby require even more rate hikes to smother inflation.

There is much more work to be done in the fight against inflation, though the collapse of SVB has made that work immeasurably harder. The Fed will need more help from the rest of government to have any chance at success.