Fed Struggles to Balance Financial Stability and Inflation Control Amidst Looming Crisis

US Federal Reserve Governor Jerome Powell finds himself in a place no central banker wants to be: working to prevent a credit crunch, which requires looser monetary policy, while battling accelerating inflation, which requires countermeasures. says the Wall Street Journal.

The turmoil in the banking industry that followed the collapse of three mid-sized lenders this spring helps explain why some central bank officials are inclined to keep interest rates steady at this week’s meeting — even though the economy and inflation haven’t slowed all that much. , as they expected.

Fed officials don’t think a crisis is imminent, attributing the recent problems to idiosyncrasies at the three banks. But current and former central bankers say that if tensions worsen, the Fed will face a more difficult trade-off. Powell and his colleagues will have to choose between focusing on failing banks or red-hot inflation.

“They are between a rock and a hard place. The situation is very, very difficult,” commented Raghuram Rajan, a former governor of India’s central bank. “You’re doomed if you raise rates significantly more and put more pressure on the banks, but you’re also doomed if you don’t” and inflation has continued and accelerated, Rajan adds.

One risk is timing: If inflation takes root in public psychology, it could force the Fed to keep short-term interest rates higher for longer.

“If inflation cools quickly … we may be able to cut rates, if not this year, then soon next,” Minneapolis Federal Reserve Governor Neal Kashkari said in an interview last month. “But if, on the other hand, inflation is much more persistent and much stronger…then I think the stress on the banking sector is likely to become more severe,” he added.

The economic expansion, confidence in the Fed and Powell’s legacy are at stake. Powell was appointed to a second term as Fed governor in part because of his popularity in Congress, with his initial response to the Covid-19 shock in 2020 and his handling of former President Donald Trump’s attacks winning the sympathy of both Democrats and Republicans.

But the last two years have proved much more complicated. First, the Fed misjudged inflation. More recently, the department’s work on bank regulation has come under fire.

Separation principle

During the pandemic, the Fed signaled plans to keep interest rates very low for years and bought trillions of dollars of bonds to spur additional borrowing as the government poured additional stimulus into the economy. These moves have flooded banks with deposits in 2021.

When inflation hit 9% last year, Powell accelerated rate hikes because he and his colleagues wanted to stop the inflationary mindset from taking root.

By February, the Fed had raised rates by 4.5 percentage points in a year—faster than any such cycle in 40 years.

Bank supervisors did not immediately notice how these rising rates had created a dangerous mismatch between some banks’ assets—low-interest securities and loans—and liabilities—deposits and other higher-interest loans.

This triggered the collapse of Silicon Valley Bank (SVB) in March.