Fed Preview

I’m losing track. So many bank bailouts … Silicon Valley, Signature, Credit Suisse, now First Republic. And that doesn’t count last November’s implosion of FTX, which differs because it wasn’t technically a bank and it was based on blatant fraud. Today’s First Republic bailout is also distinguished by being funded by other banks. This is well received, as it not only emphasizes the private sector but sends a message that despite a few land mines, the banking system as a whole is in pretty good shape, considering its fundamentally flawed fractional reserve foundations.

How will these events figure into next week’s FOMC monetary policy decision? The question mark makes this the most interesting decision in a while. These events have all come during the committee’s “quiet period”, during which it adopts a self-imposed vow of silence. The last guidance was for either a 25 bp or 50 bp increase. Now speculation has added 0 and -25bp options. The tail probabilities are unlikely, but not zero, leaving a 75 bp range of possibilities for Wednesday’s announcement.

Despite having followed the Fed for the better part of three decades, I have no special insight. We know the Fed doesn’t like to surprise markets, so the most likely outcome as of this hour (it could change by the next) is 25 bp, which would take the Fed funds floor to 4.75%. Failure to hike at all might actually spook markets by conveying a sense of panic. This factor has been widely cited as one behind this morning’s decision by the European Central Bank to follow through with the 50 bp hike it had penciled in. In the unlikely event the Fed also does 50 bp, it would undoubtedly be accompanied by emphatic promises of liquidity support to the banking system should it be needed.

The rate decision doesn’t matter as much as the financial press makes out, though. The bond market, where it counts most, has already enacted a large rate cut.

The bigger problem for the Fed right now is these rescues making a mockery of its QT program. The Fed’s balance sheet has already exploded by $300B, and JP Morgan estimates they could total to roughly $2T of stealth QE, more than offsetting all of the QT having been done in this cycle to date. After some grudging progress on tightening financial conditions over the past couple of weeks, stock prices soared again today. Should this continue it will further impede and even reverse progress on quelling consumer inflation. The Fed would much prefer an orderly decline in stock prices, much like we saw for most of last year, but without the drama of financial crises popping up like weeds. It doesn’t always get what it wants though. Exhibit A: 2008.

The Fed is in a tough spot. It can’t let the banking system unravel; that’s its charter mission. On the other hand, letting inflation get out of hand would vaporize what’s left of its credibility and pose an existential threat to itself as an institution, let alone inflict years of hardship on the average American. The least bad of its options is likely to power ahead with its inflation battle while standing ready to patch up any holes in the banking system as surgically as possible.

It could widen its toolkit beyond its balance sheet and target rates.  One dimension that has received little attention is reserve ratios. They were reduced to zero in the midst of the coronavirus crash on March 26, 2020. Raising bank reserves could both tighten financial conditions and increase confidence in bank liquidity at the same time.

3 thoughts on “Fed Preview

  1. cb says:

    I recently read an shared (thanks. you provided it.) article by Doug Casey


    Casey said: “In the business of accepting time deposits, a banker is a dealer in credit, acting as an intermediary between lenders and borrowers.”

    Questions: Why couldn’t we just as aptly call the banker a dealer in debt? When a banker accepts a time deposit, is the banker not extending debt in exchange for credit extended by the depositor?

    The banker owes the deposiitor, I would advocate that the source of the bankers business is being a debtor.

    1. Bill Terrell says:

      Great question CB. A lot of financial jargon seems calculated to confuse. Credit and debt are basically two words for the same thing, opposite sides of the same coin. If you lend me $100, you have extended credit, I have taken on debt.

      Your link is the same as in the first paragraph of my post above. Casey delves into the history of banking to illustrate the problem. The short version is that banking evolved as a way to broker lending, to bring lenders and borrowers together. Say you want to borrow a $1000 for ten years. Without an intermediary, you have to find someone who wants to lend $1000 for ten years. A lender who wants to lend $5000 for two years would likewise have to find someone who wants to borrow $5000 for two years. Messy business.

      So banking arises as a way to pool funds from lenders and borrowers with different goals. The banker earns a profit for providing this service, from the spread between the interest paid by the borrower and that paid to the lender. All legitimate and above board.

      But some bankers got greedy. They realized they could lend out more than had been lent to them by cutting corners on terms. They could accept funds callable on demand (deposits) and lend them out longer term on the statistical probability that the depositors won’t all show up at once and ask for their money back. The same funds could simultaneously be lent out while still pledged to depositors. Fractional reserve banking was born.

      But Murphy’s law happens. Drawn by the lure of easy profits, they pushed it to the limit until one day depositors demand more than the bank has on hand. The result was bank runs and financial crises. But rather than return to honest banking, they hit on the idea to form a reserve bank that would step in and provide funds whenever they fell short, acting as a facilitator for their dodgy practices. They bought the approval of politicians by proposing this reserve bank would also serve as a bottomless piggy bank for their spending.

      You know the rest.

  2. Bill Terrell says:

    Update: It still appears that a 25 bp hike is the most likely rate target announcement. The bigger news will be elsewhere. What do they say about the banking crisis? And their response? So far the discount window has been thrown wide open, and the same with swap lines to several other major central banks.

    Rates? The talk about ongoing hikes will evaporate. The course of Fed funds targets will be on a wait-and-see basis. It wouldn’t be the least bit surprising if this meeting concludes this hiking cycle. The bond market has already slashed rates, and the Fed won’t fight the bond market.