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Silicon Valley Bank’s Wake Up Call for the Federal Reserve

Especially after SVBs failure, we must hope that it is not beyond the Fed’s grasp to anticipate that there will be many other casualties of its newfound monetary policy religion as high interest rates and a weaker economy increase the incidence of loan defaults. We also have to hope that the Fed is preparing itself for likely increased financial market turbulence as a result of an anticipated bruising debt ceiling later this summer. If instead, the Fed continues to look in the rearview mirror and continues to raise interest rates by ignoring the financial troubles that lie ahead, we should brace ourselves for a very hard economic landing.

U.S. Dollars. Image: Creative Commons.
Image: Creative Commons.

Silicon Valley Bank (SVB) and Signature Bank’s recent failures were rude reminders to the Federal Reserve that financial market things tend to break when the Fed abruptly shifts from a prolonged period of monetary policy ease to one of rapid monetary policy tightening. Those bank failures also now seem to be rudely reminding the Fed that bank failures bring in their wake credit crunches that have the potential to tip the US economy into a recession.

Silicon Valley Bank Dilemma 

Over the past year, in its quest to regain inflation control, the Fed has been almost exclusively focused on past inflation and employment numbers in setting interest rates. Conspicuously absent from its interest rate policy deliberations have been financial sector disruptions that might lie ahead as a result of higher interest rates. The Fed has been running the economy like a driver looking in the rearview mirror rather than at the road ahead.

With inflation proving to be stubbornly high and with labor markets continuing to be tight, over the past year the Fed has increased interest rates at the most rapid rate in the past forty years. After accustoming markets to a prolonged period of zero Fed interest rates, the Fed increased interest rates by as much as 4 ¾ percent. In doing so, the Fed seemed to have totally ignored the predictable financial sector disruptions that such a policy shift can cause and the capacity for those disruptions to derail the economic recovery.

An important old lesson of the SVB failure is that a prolonged period of easy money lulls people into a false sense of security. As in so many previous credit cycles, that in turn induces them to take on an undue amount of risk on the assumption that the easy money times will last forever.

‘In the case of SVB, its management stretched for yield by building up too large a position in the long-dated US Treasury bond market. It was only when the Fed was forced to slam on the monetary brakes to contain multi-decade inflation that SVB’s management learned too late how ill-advised was its bet on the US Treasury market. It did so by finding that higher interest substantially eroded the market value of its bond holdings.

The sad truth is that SVB and Signature Bank will prove to be far from the only finance financial institutions to have been swimming naked in the time of easy money. We already know that many regional banks will soon be in trouble not least because of their large holdings of long-dated Treasury bonds and their outsized investments in real commercial property. With post-Covid occupancy rates being so low, it must only be a matter of time before those banks have to write off a significant part of their portfolios as more and more property market-developers default.

If past experience is anything by which to go, it will be in the largely unregulated part of the financial system that more serious problems than those recently experienced by the banks will occur. These so-called shadow banks include the hedge funds, the equity funds, the pension, funds and the insurance companies. This is of the utmost concern since those institutions now intermediate very much more credit than does the regular banking system.

Like SVB, the shadow banks too stretched for yield at a time when the Fed was keeping interest rates at their zero lower bound and was flooding the market with around a staggering $5 trillion in liquidity through its Treasury bond and mortgage-backed security purchases.

This induced those institutions to lend very large amounts of money at unusually low interest rates to borrowers of questionable creditworthiness. Amongst those borrowers were the highly leveraged companies, the emerging market economies, and highly indebted Eurozone countries

Especially after SVBs failure, we must hope that it is not beyond the Fed’s grasp to anticipate that there will be many other casualties of its newfound monetary policy religion as high interest rates and a weaker economy increase the incidence of loan defaults.

We also have to hope that the Fed is preparing itself for likely increased financial market turbulence as a result of an anticipated bruising debt ceiling later this summer. If instead, the Fed continues to look in the rearview mirror and continues to raise interest rates by ignoring the financial troubles that lie ahead, we should brace ourselves for a very hard economic landing.

Author Expertise

Dr. Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.

Written By

Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and multilateral lending agencies.

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