The Fed Is Doing Too Much, All at Once

Beating inflation is crucial for the Federal Reserve. But so is promoting full employment. And don’t forget about preserving the stability of the financial system.

Each of these goals is exemplary on its own. Put them all together in the current environment, however, and you get head-spinning problems.

By tightening financial conditions enough to curb inflation, the Fed has contributed to a spate of bank failures. And it may well be engendering a burst of financial instability that could spill into the larger economy in the form of rising unemployment.

It’s almost as though the good people at the Fed have been watching the movie “Everything Everywhere All at Once” and are creating its central meme: a toxic everything bagel.

Financial stability? Fine. Low inflation? Excellent. Maximum employment? Superb.

But as the movie suggests, if you put too many seemingly benign elements together and add vastly more complexity, before you know it you’ve concocted a self-contradictory, nihilistic mixture that can spin your quiet world utterly out of control.

“This is a very uncomfortable moment,” Mark Zandi, chief economist at Moody’s Analytics, said in a conversation on Tuesday. “I think it’s going to be OK, yet I also think we’re just one or two or three small bank failures away from people losing faith in the system, losing faith that their money is safe, and if that happens, who knows?”

To be clear, Mr. Zandi is cautiously optimistic about the strength and stability of the economy, and the Fed’s battle against inflation. And from what I can see so far, the Fed, the Treasury, the Federal Deposit Insurance Corporation and other regulators are doing a solid job of keeping the financial system working during this turbulence.

So if you are a long-term investor, you may be best off sticking to your plans — as long you are confident that you can ride out the difficulties that may be ahead. Whatever your horizon and risk appetite, it’s particularly important to keep cash in a handy and safe place, like an F.D.I.C.-insured bank account, or a money-market fund that holds high-quality government securities.

Odds are that further unpleasantness is in store. The financial system is under stress, and fresh problems could start popping up in a multitude of unexpected places.

Bank Failures

As the week’s congressional hearings emphasized, the regional banks that failed had idiosyncratic problems, yet were hurt by systemic pressures that are affecting countless institutions.

In California, Silicon Valley Bank, which had a big clientele in the tech community, collapsed on March 10 in the biggest single U.S. bank failure since the 2008 financial crisis. It was a classic bank run with a 2023 spin: Social media spurred the panic, and it involved billion-dollar depositors. In New York, Signature Bank had active franchises not only in commercial real estate but also in cryptocurrency. It, too, succumbed after depositors took money out en masse.

Regulators stepped in at both banks. Invoking emergency authority, they made sure depositors had access to their money — even those with more than $250,000 in deposits, the standard F.D.I.C. limit. New operators are running the failed banks now.

Who’s at Fault?

There’s plenty of blame to go around.

To start, there is evidence that these particular banks were badly run. Michael S. Barr, the Fed’s vice chair for supervision, assessed Silicon Valley Bank bluntly. Its “failure is a textbook case of mismanagement,” he told a Senate committee. Martin Gruenberg, chairman of the F.D.I.C., was as unsparing about Signature Bank, whose “management could not provide accurate data” on how much emergency cash the bank needed to survive.

Supervision by regulators appears to have been inadequate. The weakening of the Dodd-Frank law, which had been aimed at preventing a repeat of the financial crisis of 2008, had something to do with the current troubles, too. Medium-size banks were excused from the full force of federal regulations in 2018 during the Trump administration — with the support of former Representative Barney Frank, Democrat of Massachusetts and one of the law’s authors, who joined the Signature board in 2015.

Members of Congress and the White House are considering tighter regulations — too late for these banks, but perhaps in time for future problems. Investigations are underway.

The Fed’s Role

The Fed’s own monetary policies have contributed to the stress. In a big way.

Consider that in the current bailouts, the Fed has set up a new money funnel: the Bank Term Funding Program. Don’t let the dull name fool you. This program has powerful properties.

In essence, it temporarily immunizes troubled banks from the colossal decline in bond prices and mortgage-backed securities that was largely caused by the Fed’s campaign to fight inflation by raising interest rates.

Anyone who owns bonds fund knows all too well that last year was among the worst ever for bonds. When bond yields (a.k.a. interest rates) rise, bond prices fall, and they have rarely fallen so much.

Banks bought tons of long-term bonds when interest rates were low. By now, they may collectively face paper losses of as much as $1.7 trillion in these holdings, according to three economists, Itamar Drechsler of the University of Pennsylvania and Alexi Savov and Philipp Schnabl of New York University.

With the Fed’s new emergency bailout program, however, banks that need cash can present these badly depreciated securities to the Fed and, as if by magic, receive full value for them for up to a year.

This is not only a clever fix but a reasonable one, when you consider that the Fed is harboring similarly staggering paper losses on its own balance sheet because of its innovative policies since 2008. It bought nearly $9 trillion in bonds and other securities through quantitative easing, which gave a big boost to the near-zero interest rates that it imposed to stimulate the economy in the recessions of 2007-8 and 2020.

Now, with inflation soaring, the Fed has been raising interest rates and — until these bank bailouts — reducing its trove of securities, through quantitative tightening.

The Quandary

What’s fascinating about these banking problems is that they not only were partly caused by the Fed, but are a boon for it right now — and will continue to be, as long as they remain reasonably well contained. Squelching inflation is the Fed’s goal, and a credit crunch set off by bank failures could get it there quickly. Jerome H. Powell, the Fed chair, said as much at a news conference on March 22.

“In principle,” he said, “as a matter of fact, you can think of it as being the equivalent of a rate hike or perhaps more than that.” How big is the effect on the financial system? He said he couldn’t “make that assessment today with any precision whatsoever.”

One reason for imprecision is that the Fed has limited direct sway over what are known as “shadow banks.” These include money market funds, whose nearly 5 percent interest rates have been attracting billions in dollars from traditional banks; private equity firms that control large swaths of the economy; and mortgage-issuing companies that finance most private home buying. The problems affecting traditional banks are affecting these institutions, too, but in less discernible and quantifiable ways.

It’s also hard at this stage to assess the broad effects of financial tightening on important sectors of the economy, like commercial real estate, that have been badly hurt by rising interest rates — and by the reluctance of many workers to return to the office. Commercial real estate mortgages are disproportionately held by regional banks, which could become serious trouble spots.

What’s also remarkable is that the Fed could ease many of these problems if it began flooding the economy with money, as it did in previous crises. But as long as inflation is too high, it will be reluctant to pivot.

Of course, a major financial collapse and accompanying economic downturn would change the Fed’s plans. That happened before, with the collapse of Lehman Brothers in 2008 and the spread of the Covid-19 pandemic in 2020.

With luck, nothing like that will happen. Perhaps the Fed will beat inflation without having to change course prematurely. That’s possible, and I’m hoping for it.

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