That puts the Fed in a very difficult spot this week as officials meet to figure out what level of rate hikes can continue to bring down inflation without destroying the banking system. They have to deal with twin threats to the economy – inflation and banking stability.
After the collapse of Silicon Valley Bank, Washington asks: Is it to blame?
How did we get here? Here, in seven charts, is a look at how the Fed’s fight against high rates helped trigger instability in the banking sector.
1. Prices began to rise early in the pandemic – and continued.
The economy almost came to a standstill when covid took hold in March 2020. More than 20 million workers lost their jobs. Schools, restaurants, gyms and countless other businesses are closing their doors. Everyone was ordered to stay home.
As a result, the economy plunged into a steep recession.
When things opened up again – and people started spending again, armed with new stimulus funds – there were large shortages, supply chain spins and production hiccups that fueled inflation. Demand for goods soared, while supply remained tight. The result: higher prices.
But the Fed did not act. Policymakers, including the president, were adamant that inflation was temporary and would correct itself once pandemic-related shocks subsided.
It wasn’t until December 2021, when inflation hit a 40-year high of 6.8 percent, that Fed officials started talking about raising interest rates. They finally did – by a modest quarter of a percentage point – in March 2022. At that time, prices had risen by a whopping 9 percent from the previous year.
Timeline: US policymakers misjudged the inflation threat until it was too late
2. The Fed tried to catch up by aggressively raising interest rates.
Since then, the central bank has raised interest rates seven more times with the goal of slowing the economy enough to curb inflation.
But a series of new complications — including the war in Ukraine, which led to higher gas and energy costs — forced the Fed to redouble its efforts. Each interest rate jump provided a shock to the economy, although it was not immediately clear what the end result would be.
3. The Fed’s actions led to higher borrowing costs.
The central bank controls only one interest rate: the Federal Funds rate, which is what banks use to lend money to each other overnight.
That rate has risen from nearly zero to about 5 percent in the past year, the fastest increase on record.
And it doesn’t take long before the banks pass on the higher borrowing costs to the customers: mortgages, business loans and other forms of lending have all become more expensive in the past year.
Four ways the Fed’s rate hike could affect you
4. Bond market sees biggest drop ever in 2022
Bonds, which are loans to a company, or in this case the government, typically pay fixed interest rates and are seen as safe and reliable investments.
And while the Treasury always issues a lot of bonds, it has issued even more in the past 10 years because that’s how the US government finances expensive projects. Trump tax cuts. Pentagon budget. Covid-era stimulus programs to prop up the economy under Trump and Biden.
See how the national debt grew to $31 trillion
But as interest rates rose, investors were more interested in new bonds that promised to pay more, and long-term bonds tied to older, lower interest rates became less desirable — and therefore less valuable.
As a result, the bond market took a dive last year, recording its steepest decline.
5. It was bad news for banks like SVB, which had invested heavily in fixed-rate bonds.
In recent years, banks – recently flushed with extra deposits from pandemic-era savings and stimulus – have been bulking up on bonds and other fixed-income investments like mortgage-backed securities. At SVB, by the end of 2022, fixed-interest securities accounted for almost 60 percent of the bank’s assets.
But when the Fed raised interest rates, those bonds became worth less. SVB’s $91 billion portfolio of long-term securities was worth only $76 billion at the end of 2022. That $15 billion difference was far greater than the $1 billion loss the company reported a year earlier.
In addition, the vast majority of the bank’s deposits — nearly 94 percent — were uninsured, according to data from S&P Global. The national average is about half that, which made SVB particularly vulnerable to fears of a race becoming self-fulfilling. The bank’s customers withdrew $42 billion in just 24 hours, leaving the bank with a negative balance of $1 billion.
“It’s simple: When interest rates go up, the value of bonds goes down,” said Darrell Duffie, professor of management and finance at Stanford University. “Silicon Valley Bank had a whole lot of bonds — both Treasuries and mortgage bonds — so when the Fed raised interest rates to try to reduce inflation, the value of all those bonds went down.”
It would not have been a big deal if SVB had been able to hold on to its bonds until they expired. But with a flood of depositors clamoring to take their money from the bank, SVB had no choice but to sell its securities at a massive loss. The bank quickly collapsed.
“It was a classic bank run,” Duffie said.
The 72-hour battle to save America from a banking crisis
6. Countless other banks are still sitting on billions in devalued Treasuries.
SVB was not alone in its stock of falling bonds. US banks are sitting on a staggering $620 billion in unrealized losses, according to the FDIC.
The Federal Reserve stepped in last week with an emergency program that allows banks to trade devalued bonds at their original value in cash. While this offers a temporary solution, economists say there may be other unforeseen problems lurking in the financial sector.
“So far, we’ve been able to prevent major spillovers — the central bank and others have come in with quick fixes to prevent this from metastasizing into a broader banking crisis,” said Dana Peterson, chief economist at the Conference Board. “But there may still be more shoes to drop.”
The Fed has moved quickly to contain a broader financial crisis, launching a new emergency loan program with generous terms to complement its existing “discount window” for emergency loans. The measures are so far gaining traction with the banks loans at the window reached a record high of $153 billion last week.
What is the Fed’s discount window and why do banks use it so much?
The whirlwind events of the past week and a half have raised new questions about the Fed’s next move.
The European Central Bank last week stuck to its aggressive plan to raise interest rates by half a percentage point for the euro zone despite problems for Swiss giant Credit Suisse, which required the bank to borrow up to $54 billion from the Swiss National Bank.
Many experts and investors still expect the central bank to raise interest rates by another quarter of a percentage point when it meets on Wednesday, although there are growing concerns that the financial system may be too fragile to handle the higher rate.
That’s a sharp turnaround from earlier this month, when Fed Chairman Jerome H. Powell floated the possibility of raising interest rates by half a percentage point, citing stronger-than-expected readings on inflation and employment. The economy added more than 800,000 jobs in the first two months of this year, and inflation remains high, with prices up 6 percent from last year.
But all this is now in the rearview mirror as investors worry about the potential cascading effects of bank failures and increased market stress.
“The Fed still wants to raise rates a little more,” said David Donabedian, chief investment officer of CIBC Private Wealth US. “It’s just a question of whether the volatility of the banking system will allow them.”