Fed Walks Tightrope Between Inflation and Financial Instability—but for How Long?

In reality, of course, these two jobs aren’t so easily separated. Higher interest rates cool growth and inflation through a range of channels, one of which is raising financial institutions’ own cost of borrowing, causing them to lend less. The process usually plays out smoothly but sometimes violently: Banks or less-regulated lenders fail or come close to failing, assets crater and the public panics, whacking the economy more than the Fed intended. This is the origin of the Wall Street adage, “The Fed tightens until something breaks.”

In its actions Wednesday, the Fed recognized that something was breaking. Recent data had pointed to economic growth accelerating and underlying inflation remaining stubbornly high. Fed Chairman

Jerome Powell

indicated to Congress earlier this month that the trends likely would require rates to rise above 5.25%, perhaps by a lot. The projections released Wednesday show Mr. Powell and his colleagues have abandoned those plans and still see the target range for the federal-funds rate, which is now 4.75% to 5%, topping out between 5% and 5.25% this year, unchanged from December’s meeting.

“We’re looking at what’s happening among the banks and asking, is there going to be some tightening in credit conditions,” Mr. Powell told reporters. “In a way, that substitutes for rate hikes.”

Because of the expected credit crunch, Fed officials nudged expected growth down to 0.4% this year from 0.5% in their December projections, and 1.2% next year from 1.6%.

If the Fed’s forecasts and assumptions turn out right—with the bank instability largely contained and inflation now gliding back toward 2% from 5% to 6%—then the balancing act will have been a success. A truly systemic financial crisis will have been avoided at relatively low cost, in terms of financial market wreckage or inflation.

There are many other ways things could go, of course, and two in particular are of greatest concern. One is that the Fed may have overreacted. It, and other regulators, might have expanded the banking safety net for an isolated problem without truly systemic repercussions. And by lowering the path for rates this year, the Fed may have loosened overall financial conditions, setting back the fight against inflation.

There are precedents. In 1987, the Fed’s newly installed chairman

Alan Greenspan

was establishing his hawkish credentials by raising interest rates when the stock market crashed.

He then quickly cut them. The market crash left no economic imprint, inflation ground higher, and the Fed had to tighten more, resulting in a recession from 1990-91. In 1998, Mr. Greenspan again cut rates in response to the dislocations caused by a huge, flailing hedge fund, Long Term Capital Management. By the time he resumed raising rates, the internet bubble had inflated further.

Mr. Powell has steered clear of those scenarios in that he didn’t stop raising rates this week, much less cut them, and in principle could accelerate the pace of rate increases fairly easily.

The other risk is that the financial system is more fragile than the Fed realizes, and that by raising rates this week the Fed made it more fragile.

SVB

was an outlier but many banks have unrealized bond losses and a heavy dependence on uninsured deposits. Those deposits have been migrating to too-big-to-fail banks or higher-yielding money-market funds—a dynamic this week’s rate increase could aggravate. Other, unnoticed risks might lurk in the financial system.

In 2007, in the opening weeks of the financial crisis, then-Fed chairman

Ben Bernanke

tried to keep financial stability and monetary policy separate by cutting the discount rate but not the federal-funds rate. But the mortgage crisis only worsened from there and within months, the Fed was easing monetary policy.

There is little reason to think the financial system is as vulnerable as it was then. But the Fed might yet find that keeping its two jobs separate hasn’t gotten any easier.

Write to Greg Ip at [email protected]

In reality, of course, these two jobs aren’t so easily separated. Higher interest rates cool growth and inflation through a range of channels, one of which is raising financial institutions’ own cost of borrowing, causing them to lend less. The process usually plays out smoothly but sometimes violently: Banks or less-regulated lenders fail or come close to failing, assets crater and the public panics, whacking the economy more than the Fed intended. This is the origin of the Wall Street adage, “The Fed tightens until something breaks.”

In its actions Wednesday, the Fed recognized that something was breaking. Recent data had pointed to economic growth accelerating and underlying inflation remaining stubbornly high. Fed Chairman

Jerome Powell

indicated to Congress earlier this month that the trends likely would require rates to rise above 5.25%, perhaps by a lot. The projections released Wednesday show Mr. Powell and his colleagues have abandoned those plans and still see the target range for the federal-funds rate, which is now 4.75% to 5%, topping out between 5% and 5.25% this year, unchanged from December’s meeting.

“We’re looking at what’s happening among the banks and asking, is there going to be some tightening in credit conditions,” Mr. Powell told reporters. “In a way, that substitutes for rate hikes.”

Because of the expected credit crunch, Fed officials nudged expected growth down to 0.4% this year from 0.5% in their December projections, and 1.2% next year from 1.6%.

If the Fed’s forecasts and assumptions turn out right—with the bank instability largely contained and inflation now gliding back toward 2% from 5% to 6%—then the balancing act will have been a success. A truly systemic financial crisis will have been avoided at relatively low cost, in terms of financial market wreckage or inflation.

There are many other ways things could go, of course, and two in particular are of greatest concern. One is that the Fed may have overreacted. It, and other regulators, might have expanded the banking safety net for an isolated problem without truly systemic repercussions. And by lowering the path for rates this year, the Fed may have loosened overall financial conditions, setting back the fight against inflation.

There are precedents. In 1987, the Fed’s newly installed chairman

Alan Greenspan

was establishing his hawkish credentials by raising interest rates when the stock market crashed.

He then quickly cut them. The market crash left no economic imprint, inflation ground higher, and the Fed had to tighten more, resulting in a recession from 1990-91. In 1998, Mr. Greenspan again cut rates in response to the dislocations caused by a huge, flailing hedge fund, Long Term Capital Management. By the time he resumed raising rates, the internet bubble had inflated further.

Mr. Powell has steered clear of those scenarios in that he didn’t stop raising rates this week, much less cut them, and in principle could accelerate the pace of rate increases fairly easily.

The other risk is that the financial system is more fragile than the Fed realizes, and that by raising rates this week the Fed made it more fragile.

SVB

was an outlier but many banks have unrealized bond losses and a heavy dependence on uninsured deposits. Those deposits have been migrating to too-big-to-fail banks or higher-yielding money-market funds—a dynamic this week’s rate increase could aggravate. Other, unnoticed risks might lurk in the financial system.

In 2007, in the opening weeks of the financial crisis, then-Fed chairman

Ben Bernanke

tried to keep financial stability and monetary policy separate by cutting the discount rate but not the federal-funds rate. But the mortgage crisis only worsened from there and within months, the Fed was easing monetary policy.

There is little reason to think the financial system is as vulnerable as it was then. But the Fed might yet find that keeping its two jobs separate hasn’t gotten any easier.

Write to Greg Ip at [email protected]