As concerns about bank stability and persistent inflation continue, it\u2019s likely that Federal Reserve Chairman Jerome Powell will announce a 25 basis point (bp) rate hike this afternoon. A quarter-point hike is the sweet spot that demonstrates sensitivity to financial stability risks while simultaneously maintaining discipline on the inflationary front. Fortunately for the Fed, its decision later today comes as efforts by both the U.S. government and large banks have helped calm fears of a banking contagion. Without these integral interventions, the Fed may have been compelled to delay its inflation battle in the name of financial stability.<\/p>\n\n\n\n
Under normal circumstances, the Fed strikes a balance between stabilizing inflation and maximizing employment, but the recent high-profile banking failures have complicated matters. Overall inflation has been slowing but remains nowhere close to the Fed\u2019s 2% inflation target. In fact, the Fed\u2019s preferred inflation gauge, the core PCE, is at 4.7%, with the services sector demonstrating persistent price gains. While demand declines have weighed on goods and commodity prices to an extent, the tightest labor market in ages is sporting fewer than 200,000 initial unemployment claims per week. Restoring price stability requires softening labor market conditions, even as financial stability risks mount. The Fed is between a stone and a brick wall. <\/p>\n\n\n\n
Even though the Fed realizes that strong inflation is unacceptable, it has boosted liquidity levels to safeguard the banking system, which counteracts progress on subduing price pressures. As the Fed has raised interest rates for much of last year, prices of long-duration bonds held on banks\u2019 balance sheets have cratered. Last year, banks lost $620 billion in long-duration bond values, and additional losses have occurred year-to-date with fears of financial stability sparking a bank run consisting of billions of dollars in withdrawals. To meet withdrawal requests, banks have been forced to sell bonds from their portfolios, thereby realizing huge balance sheet losses. <\/p>\n\n\n\n
Today\u2019s Fed meeting, however, comes after the U.S. Treasury, the Federal Reserve and the Federal Deposit Insurance Trust Corp. announced the extraordinary measure of protecting approximately $175 billion in deposits at failed Silicon Valley Bank (SVB) and $88.6 billion in deposits at failed Signature Bank rather than just the $250,000 per account ceiling. Yesterday, Treasury Secretary Janet Yellen explained that government actions have helped stabilize bank withdrawals and that the government will consider protecting bank deposits at smaller banks if needed. Additionally, shares of troubled First Republic rallied yesterday on news that JP Morgan Chase CEO Jamie Dimon is leading a banking group that is considering providing a fresh capital infusion into the regional bank. First Republic already received $30 billion in deposits from 11 big banks after it suffered from more than $70 billion in withdrawals in the aftermath of the recent collapse of SVB and Signature. At one point this month, First Republic\u2019s shares had declined 90%.<\/p>\n\n\n\n
One issue going forward is just how much in assets banks will have to write down and if future bank runs will occur. Researchers at the University of Southern California, Northwestern University, Columbia University and Stanford\u2019s Graduate School of Business have determined that marked-to-market bank assets, which are assets held for meeting redemptions, have declined in value by an average of 10% across all banks. Held-to-maturity assets, which for accounting standards are valued at face value, have seen market trading prices decline by $2 trillion relative to book value. If a significant bank run occurs that depletes banks\u2019 marked-to-market assets, then banks would be forced to sell their held-to-maturity assets as a substantial loss.<\/p>\n\n\n\n
In Europe, meanwhile, regulators have forced UBS to acquire troubled Credit Suisse for $3.25 billion. Credit Suisse had issued $17 billion in AT1 bonds that were intended to protect banks during periods of instability without relying on taxpayer bailouts. In some instances, the bonds can be converted to equities. UBS executives have convinced the Swiss government to completely write down the value of the bonds so that the securities don\u2019t become a burden. While Credit Suisse equity holders will receive a payout, a handful of AT1 investors are considering filing a lawsuit against Swiss regulators to oppose the bond write downs.<\/p>\n\n\n\n
While Treasury Secretary Yellen has commented on the banking sector being better positioned than during the 2008 financial crisis, this time is certainly different from a portfolio standpoint. Due to the duration mismatches and interest rate risk in many regional bank portfolios, for now, this time resembles the 1980s a lot more as loan delinquencies haven\u2019t become a widespread problem just yet. As former Chairman of the Fed Paul Volcker and previous FDIC Chairman William \u201cBill\u201d Isaac dealt with persistent inflation and thousands of bank failures, the era offers significant perspective in the tradeoffs necessary to control inflation. Volcker and Isaac are credited with slaying the inflation dragon while accepting painful tradeoffs regarding financial stability.<\/p>\n\n\n\n
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