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The Canary in the Fed's Coal Mine

Timing is everything. Imagine publishing a book two weeks before a major crisis that is perfectly explained in its pages. Jeanna Smialek just did that. If you want to understand the financial crisis slowly unfolding right now, you can do no better than to read Limitless: The Federal Reserve Takes on a New Age of Crisis.

If you took an economics course back when you were an undergraduate, you may think that you know what the Federal Reserve does. Your monetary policy education, however, is probably out of date. March 23, 2020, is a date that means little to most people, but it is, as Smialek dubs it in a chapter title, “The Day the Fed Changed.” This is the story of a revolution, but because there were so many things happening in those days of Covid panic, not many people noticed. 

A Changing Fed

Beginning in the early 1980s, there was a quarter century of widespread agreement that the role of the central bank was to keep inflation under control. That consensus did not come about easily. Milton Friedman began arguing for the idea in the 1960s, but it took the high inflation of the 1970s and the recession of the early 1980s to convince most people. In the years in which Volcker and Greenspan ran the Fed, there was very little argument about the goal.

The financial crisis of 2007–08 chipped away at the consensus. A looming collapse of the shadow banking system, which became particularly acute the day Lehman Brothers failed, convinced the Fed to do what it could to minimize the extent of the financial system collapse. There is little argument that the Fed did a good job in late 2008.

What came after 2008 is where the modern story begins. From the end of the financial crisis through 2020, the Federal Reserve kept interest rates extremely low; economic growth and inflation also stayed low. The Fed’s regulatory power over the financial system was enhanced, but financial institutions seemed to be playing things safer than they had in the pre-2007 era. It was a lull before the storm.

Whatever limits used to constrain the Fed no longer existed. If municipal governments are running into financing problems, the Fed was there to help. When the junk bond market started getting problematic, the Fed showed up with checkbook in hand. 

The crisis hit in March 2020, and this time it did not come from complicated financial instruments based on subprime mortgages. The crisis came from a virus, which caused government shutdowns of wide swaths of the economy. The sudden cessation of economic activity created a massive crisis in the financial sector. When the Fed saw assorted financial markets beginning to behave in potentially disastrous ways, it pulled out the playbook from 2008 to shore up financial firms. It wasn’t enough. 

Then came March 23. That day, the Fed announced it was there to stabilize the market for securitized loans based on things like credit card debt and auto loans. Moreover, if corporations needed funds, the Fed was standing ready to buy existing debt and even brand new debt. A Main Street loan program was created to do something unspecified to help out smaller firms across the country. And finally, the Fed promised to buy as much government debt as it would take to keep that market highly liquid. As one wag put it, “The Fed [is] throwing the kitchen sink and more, all the stuff under the stove and in the closet, at the markets.” 

The cumulative effect of those changes was an explicit promise that the Fed would do whatever it took to make sure there were no financial failures of any sort. “Racing Across Red Lines” is the title that Smialek gives to the chapter following the description of these changes. It turns out March 23 was just the beginning; there was stuff in other rooms too which could be thrown at the problem. Whatever limits used to constrain the Fed no longer existed. If municipal governments are running into financing problems, the Fed was there to help. When the junk bond market started getting problematic, the Fed showed up with checkbook in hand. 

The end of the financial crisis of 2020 did not change the Fed’s new outlook. Most significantly, that hard-won consensus that Federal Reserve policy should be focused on keeping inflation low was shattered. The new goal was to keep unemployment as low as possible. In August 2020, Jerome Powell dropped a bombshell: “Our policy decision will be informed by our ‘assessments of the shortfalls of employment from its maximum level’ rather than by ‘deviations from its maximum level’ as in our previous statement.” Smialek explains:

The change seemed innocuous, even pedantic, as big moments in central banking often do. 

In fact, it marked something revolutionary. Now the Fed was effectively saying that it would not raise interest rates based purely on a suspicion that the labor market had heated up too much. Officials now cared only about “shortfalls”—too little employment would be a reason to leave rates low. They were giving up on trying to understand what constituted “too much” employment.

A half-century of monetary theory was tossed out the window and the Fed was no longer concerned that if it tried to lower unemployment too much, inflation would return. 

All by itself, this shift in the focus of monetary policy is shocking. But Smialek notes in detail that this was not the only change. Internal debates at the Fed turned far away from things in the traditional realm of monetary policy. Climate change, income and wealth inequality, racial diversity, and education all became hot topics. A community outreach program called Fed Listens was launched in which top Fed officials including Powell went to community gatherings to chat with regular folks. Whatever you wanted to discuss, the Fed was there to listen.

The Aftermath

The full effects of the changes in the Fed’s behavior in March 2020 were not immediately seen. As Milton Friedman documented decades ago, it takes one to two years for a rapid change in the money supply to show up as inevitable inflation. And just like clockwork, inflation started rising in mid-2021. The Fed loudly insisted at the time that the inflation had nothing to do with them, that it was transitory and would soon vanish. A year later as inflation kept rising, they finally started to act.

The Fed’s actions, however, are best described as tentative. It had just spent two years telling everyone that unemployment was a far bigger problem than inflation and that everyone could safely ignore all those warning signs about inflation. To act decisively against inflation would mean a sharp increase in interest rates; the effect of that action would have been a recession. So the Fed, still using its new playbook, made its goal to reduce inflation conditional on not causing a recession. Bit by bit it inched interest rates up, spending more time watching the measures of economic activity than what was happening with core inflation.

What makes Smialek’s book so timely is that it came out two weeks before Silicon Valley Bank (SVB) collapsed. This is as close as you can possibly get in economics to a natural experiment. If Smialek’s story is right, then can we explain what happened to SVB? Indeed we can.

For fifteen years, the Federal Reserve had been committed to keeping interest rates very low, and since 2020, the Federal Reserve had been very explicit that it had no intention of changing things. 

SVB was a midsized bank whose deposits had more than tripled in the last few years. As suggested by their name, they made a fair number of loans to tech start-ups. But, having all your assets in risky loans to new firms is undesirable. What are the safest assets you can buy to balance your portfolio? It turns out US banking regulations are very explicit about what constitutes a safe asset. The safest of all assets, the asset that banking regulations strongly encourage banks to hold, is US government debt. So, Silicon Valley Bank held a lot of government debt.

What was somewhat unusual about SVB is that they had mostly purchased long-term government debt. The advantage of the longer-term debt was that it paid a slightly higher interest rate. Because bond prices and interest rates are inversely related, if you are holding long-term bonds, there is a risk that their short-run value will fall when interest rates rise. After the fact, it is obvious that SVB was holding far too many long-term government bonds. But, before the fact, was that an obvious problem? For fifteen years, the Federal Reserve had been committed to keeping interest rates very low, and since 2020, the Federal Reserve had been very explicit that it had no intention of changing things. 

When the Fed did start raising interest rates, a holder of long-term bonds like SVB was faced with a choice: It can sell the bonds immediately and take an immediate loss, or it could continue to hold the bonds, face no immediate loss, and wait until maturity to get exactly what it originally expected to get. Since the Fed was tentatively raising interest rates, after each increase the press was full of people arguing that this was probably the last time the Fed would need to raise rates. But, rates kept going up, and the value of SVB’s portfolio kept falling. 

In February of this year, the Fed made the smallest interest rate increase in a year. Powell added that the end was in sight and that there were probably only a couple more interest rate increases coming along in the future. Then suddenly on March 7, with inflation signs stubbornly persisting, Powell announced that maybe they were going to have to be more aggressive on interest rates after all. The next day, SVB, faced with the prospect of an even greater collapse in the value of all their US government debt, announced it needed more funds. On March 9, some large depositors at SVB started to get worried and withdrew their deposits, and SVB had to start selling its bonds at the reduced prices. On March 10, the regulators closed the bank.

The Fed and the Treasury then swooped into action to control the collateral damage. The 2020 playbook was open and ready. The Fed promised to keep things afloat. The Treasury promised to ensure all depositors, even those with deposits far above the FDIC limit.

When you step back and look at that story, all the parts of the tale told by Smialek are evident. When the Fed became more concerned with keeping unemployment low, it stopped worrying about inflation. Moreover, short-run financial stability is now a top priority of the Fed, regardless of the long-run implications. The result has been to make the whole system even more unstable. Financial firms now rely on the Fed to maintain a low-interest rate policy, and they are certain, should they run into big enough trouble, that the bailouts will soon follow. 

The Fed has put itself into a box and there is no easy way out. An attempt to stop the looming inflation could result in an increasing number of Silicon Valley Banks. Taking steps to avoid potential problems in the financial sector could result in even higher inflation in a year or two. Bringing down inflation without a sharp recession may not be possible, but the only way it is even theoretically possible is if the Fed has credibility when it promises to lower inflation. As Smialek’s book makes painfully clear, there is no reason to trust the Powell Fed’s promise to lower inflation if the cost seems high. Now that the Fed’s ambitions are limitless, there is nobody left to keep inflation under control.