The Fed will prioritize financial stability over the fight against inflation By Les Nemethy, CEO, Euro-Phoenix M&A Advisors, former World Banker

For the past six months, the US Fed has been fighting inflation by jacking up interest rates and tightening money supply to fight inflation. This author, and others, predicted that “something will break”. Something did break: Silicon Valley Bank (SVB). And now the Fed is busily trying to contain the contagion.

This article discusses how the financial stability goal trumps fighting inflation; the longer financial instability persists, the more the goal of fighting inflation will take a back seat. The ramifications are far-reaching. If my hypothesis is correct, we could see another major inflation spurt in the coming year. My reasoning is summarized in the following five points.

A. Recent statistics demonstrate that inflation fighting has taken a back seat

The chart below shows how assets of the US, European and Japanese Central Banks have been selling down assets for the past year (e.g. tightening the money supply). In the first half of March, 2023, considerable loosening has occurred. This is inflationary.

Exhibit 1: G3 Combined Central Bank Balance Sheets

B. There is still considerable potential for future contagion

Let us examine the how SVB failed. SVB, as the premier banker to Silicon Valley tech firms, amassed huge amounts of deposits. It chose to invest most of these deposits into long-term Treasuries– when interest rates were lowest (e.g. Treasury prices were at their peak). Then the Fed jacked up interest rates– the steepest increase in interest rates in percentage terms in the history of the Fed. Bond prices — being inverse to interest rates—collapsed.

SVB could have held the bonds to maturity to recover their face value—but that would have potentially taken decades. Meanwhile depositors wanted their money now, forcing SVB to liquidate bonds, thereby recognizing losses, which rapidly created a vicious circle leading to SVB’s demise.

One might say the Fed whipsawed SVB—first by keeping interest rates artificially low, then jacking them up very quickly. And how ironic, that US Treasuries, one the safest assets in the world, was the cause of SVB’s downfall.

SVB is not the only bank facing this predicament. In the US banking system alone, over $600 billion of bonds are “below water.” And that doesn’t cover shadow banks, pension funds, or foreign financial institutions. So the potential for future contagion is definitely there.

Due to the nature of fractional reserve banking, banking by definition is a confidence trick. If enough people withdraw funds from a bank. Until confidence can be restored, reverberations will continue through the financial system, despite attempts by central banks to tamp down the contagion.

C. The US and Global Economies are highly leveraged

High leverage is associated with high risk. The global economy is now more levered than ever—global Government, private and corporate debt sits at a mind-boggling 370% of global GDP, considerably higher than during the 2008 Global Financial Crisis. This has made the world much more sensitive to record fast increases in interest rates.

D. The future fight against inflation is made even more difficult

The Fed is literally between the proverbial rock and hard place. To fight inflation, the Fed and other Central Banks need to increase interest rates and decrease money supply. Yet it is a decrease in interest rates that would help to refloat the value of the underwater bond portfolio, and loose liquidity that would help take the pressure off banks in general. In the coming months we will find out whether the path is extremely narrow, or perhaps there is no path at all.

E. Ultimately, Central Banks will need to prioritize Financial Stability

If financial stability is lost—e.g. banks start falling like dominoes—we would be into a 1930’s style Great Depression. The possibilities are too horrible to contemplate—double digit unemployment, possible deflation, etc.

Central Banks cannot afford to walk anywhere near the deflation precipice. As long as sufficient stimulus is provided early enough–before major financial institutions go bankrupt– it is not that difficult to achieve financial stability. Just throw enough money at the situation! (In the most recent week, US banks borrowed $150 billion from the Fed’s discount window, blowing past the prior 2008 record of $112 billion). Short-term disaster can be averted—but at the cost of catalyzing long-term inflation. Politicians and Central Bankers have a bias to avoid disaster under their watch, and kick the problem down the road.

Loosening of monetary policy today means that we will likely face an even bigger debt bubble and higher inflation tomorrow.

So buckle up, we are likely facing a rough ride on inflation. The longer financial instability persists, the higher the inflation will be.

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