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.