Tono Curbing inflation, as the saying goes, central bankers must tighten monetary policy until something goes wrong. For much of the past year, that cliché has been easily dismissed. Beginning in March 2022, the US Federal Reserve is raising interest rates at the fastest rate since the 1980s. Even as markets plummeted, the world’s financial system did not collapse. When UK pension funds experienced volatility in September, the Bank of England was quick to help correct the problems. The most notable breakdown — ftxa disgraced ex-cryptocurrency exchange — far out of the mainstream, regulators say, is the result of fraud, not the Fed.
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Now something is broken. The failure of Silicon Valley Bank (SVB), a mid-sized US bank, sent shockwaves through the March 10 bankruptcy. Most notable was the wobble in other bank stocks, where investors fear similar weaknesses may exist. The Nasdaq bank index lost a quarter of its value in a week, erasing the previous 25 years of gains. Shares of U.S. regional banks have been hit much harder. Then the turmoil rippled around the world: shares in European bank Credit Suisse plummeted on March 15. Financial markets have entered a new phase, with the Fed’s tightening cycle kicking in.
A hallmark of this phase is that markets suddenly work with the Fed rather than against it. For more than a year, central bankers have been repeating the same message: Inflation has proven more stubborn than expected, meaning rates need to rise higher than previously expected. This message was further confirmed by data released on March 14, which showed that underlying consumer prices were once again rising faster than expected.
Policymakers want to tighten financial conditions — such as lending standards, interest costs, or money market liquidity — to reduce aggregate demand and curb price increases. The market has been moving in the other direction since October. An indicator of financial conditions compiled by data provider Bloomberg showed that financial conditions are steadily easing. All of this loosening has been reversed in the past week. SVBThe crash shocked the market and let the market do the Fed’s job.
That doesn’t mean investors have given up on fighting the Fed. They are still betting the Fed will start cutting rates soon, though officials have given no indication of such. Still, the battlefield has shifted. Earlier this year, expectations for a rate cut stemmed from hopes that inflation would fall faster than the Fed expected. Now they reflect fear. On March 13, the two-year Treasury yield fell 0.61 percentage point, the largest one-day drop in more than 40 years. Panic trading on March 15 sparked fears that the market was out of control. With some banks already failing, investors are betting the Fed will cut rates not because the inflation monster has been tamed, but to avoid spoiling anything else.
Combined with the reaction of other markets, this suggests a degree of cognitive dissonance. Broader stock market indexes fell, but not sharply.this Second&p The US Large Enterprises 500 Index was unchanged from the beginning of the year. The dollar, which tends to strengthen in crises, weakened slightly as investors flocked to safe-haven assets. On the one hand, investors believe the Fed should be fearful enough of bank failures to start cutting rates. On the other hand, they themselves are not worried enough about the consequences of this failure to be reflected in the price.
Underlying this contradiction is the tension between the Fed’s inflation target and its mandate to protect financial stability.s failure SVB, rooted in losses on fixed-rate bonds (whose value falls as interest rates rise), appears to be evidence of this. Since the importance of fighting inflation pales in comparison to the stability of the banking system, the Fed cannot afford higher interest rates. That reduces the risk of a recession, boosting stocks and reducing demand for safe-haven assets such as the U.S. dollar.
Don’t be so sure.The following SVBAfter the crash, the Fed has pledged to support other banks. Its backing — loans backed by securities worth as little as two-thirds the value of the loan — should prevent any solvent institution from failing if interest rates eventually fall. Adding to this generosity is an uncomfortable truth. To squeeze inflation out of the economy, the Fed needs to make lenders nervous, making loans expensive and businesses averse to risk.allow reckless banks such as SVB Failure is not a tragic accident. That’s part of the Fed’s job.■
Learn more from our financial markets columnist Buttonwood:
Why Commodities Shine in an Era of Stagflation (March 9)
Anti-ESG industries are attracting investors (March 2)
Wall Street takes China with reservations despite bullish rhetoric (Feb. 23)
Plus: How the Buttonwood column got its name
