Fed Will Prioritize Financial Stability Over Fight Against Inflation

Here, Nemethy discusses across five points how the financial stability goal trumps fighting inflation; the longer the instability persists, the more the idea of battling inflation will take a back seat. The ramifications are far-reaching. If he is correct, we could see another significant inflation spurt in the coming year.

1) Recent statistics demonstrate that inflation-fighting has taken a back seat.

The U.S., European and Japanese Central Banks have been selling down assets for the past year (tightening the money supply). In the first half of March 2023, considerable loosening occurred. This is inflationary.

2) There is still considerable potential for future contagion.

Let us examine how SVB failed. As the premier banker to Silicon Valley tech firms, it amassed vast deposits. It chose to invest most of these into long-term Treasuries when interest rates were lowest (in other words, Treasury prices were at their peak). Then the Fed jacked up interest rates by the steepest increase in percentage terms in its history. Bond prices, being inverse to interest rates, collapsed. 

SVB could have held the bonds to maturity to recover their face value, but that would potentially have taken decades. Meanwhile, depositors wanted their money now, forcing SVB to liquidate bonds, thereby recognizing losses, rapidly creating 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 U.S. Treasuries, one of the safest assets in the world, was the cause of SVB’s downfall.

SVB is not the only bank facing this predicament. In the U.S. banking system alone, more than USD 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 is, by definition, a confidence trick. If enough people withdraw funds from a bank… Until confidence can be restored, reverberations will continue through the financial system, despite the attempts by central banks to tamp down the contagion.  

3) The U.S. and global economies are highly leveraged.

High leverage is associated with high risk. The global economy is now more leveraged 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.

4) The future fight against inflation is made even more difficult.

The Fed is literally between the proverbial rock and a hard place. To fight inflation, it and other central banks must increase interest rates and decrease the 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. 

5) Ultimately, central banks will need to prioritize financial stability.

If financial stability is lost, for example, if banks start falling like dominoes, we would be into a 1930s-style Great Depression. The possibilities are too horrible to contemplate: double-digit unemployment, possible deflation, and so on.

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, U.S. banks borrowed USD 150 bln from the Fed’s discount window, blowing past the prior 2008 record of USD 112 bln).

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.

The loosening of monetary policy today means 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.

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of March 24, 2023.