Fed Chair Jerome Powell holding a news conference following the March 22 meeting of the FOMC. Photo from Reuters via the Wall Street Journal.
On March 22, the Federal Open Market Committee (FOMC) unanimously voted to raise its target for the federal funds rate by 0.25 percentage point to a range of 4.75 percent to 5.00 percent. The members of the FOMC also made economic projections of the values of certain key economic variables. (We show a table summarizing these projections at the end of this post.) The summary of economic projections includes the following “dot plot” showing each member of the committee’s forecast of the value of the federal funds rate at the end of each of the following years. Each dot represents one member of the committee.
If you focus on the dots above “2023” on the vertical axis, you can see that 17 of the 18 members of the FOMC expect that the federal funds rate will end the year above 5 percent.
In a press conference after the committee meeting, a reporter asked Fed Chair Jerome Powell was asked this question: “Following today’s decision, the [financial] markets have now priced in one more increase in May and then every meeting the rest of this year, they’re pricing in rate cuts.” Powell responded, in part, by saying: “So we published an SEP [Summary of Economic Projections] today, as you will have seen, it shows that basically participants expect relatively slow growth, a gradual rebalancing of supply and demand, and labor market, with inflation moving down gradually. In that most likely case, if that happens, participants don’t see rate cuts this year. They just don’t.” (Emphasis added. The whole transcript of Powell’s press conference can be found here.)
Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk–such as a sudden increase in oil prices or in interest rates–and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banks, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart shows values after trading of federal funds futures on March 24, 2023.
The chart shows six possible ranges for the federal funds rate after the FOMC’s last meeting in December 2023. Note that the ranges are given in basis points (bps). Each basis point is one hundredth of a percentage point. So, for instance, the range of 375-400 equals a range of 3.75 percent to 4.00 percent. The numbers at the top of the blue rectangles represent the probability that investors place on that range occurring after the FOMC’s December meeting. So, for instance, the probability of the federal funds rate target being 4.00 percent to 4.25 percent is 28.7 percent. The sum of the probabilities equals 1.
Note that the highest target range given on the chart is 4.50 percent to 4.75 percent. In other words, investors in financial markets are assigning a probability of zero to an outcome that the dot plot shows 17 of 18 FOMC members believe will occur: A federal funds rate greater than 5 percent. This is a striking discrepancy between what the FOMC is announcing it will do and what financial markets think the FOMC will actually do.
In other words, financial markets are indicating that actual Fed policy for the remainder of 2023 will be different from the policy that the Fed is indicating it intends to carry out. Why don’t financial markets believe the Fed? It’s impossible to say with certainty but here are two possibilities:
Markets may believe that the Fed is underestimating the likelihood of an economic recession later this year. If an economic recession occurs, markets assume that the FOMC will have to pivot from increasing its target for the federal funds rate to cutting its target. Markets may be expecting that the banks will cut back more on the credit they offer households and firms as the banks prepare to deal with the possibility that substantial deposit outflows will occur. The resulting credit crunch would likely be enough to push the economy into a recession.
Markets may believe that members of the FOMC are reluctant to publicly indicate that they are prepared to cut rates later this year. The reluctance may come from a fear that if households, investors, and firms believe that the FOMC will soon cut rates, despite continuing high inflation rates, they may cease to believe that the Fed intends to eventually bring the inflation back to its 2 percent target. In Fed jargon, expectations of inflation would cease to be “anchored” at 2 percent. Once expectations become unanchored, higher inflation rates may become embedded in the economy, making the Fed’s job of bringing inflation back to the 2 percent target much harder.
In late December, we can look back and determine whose forecast of the federal funds rate was more accurate–the market’s or the FOMC’s.
Bank borrowing from the Fed. Figure from the Federal Reserve Bank of St. Louis FRED data set.
Discount loans were the Fed’s original policy tool. As we discuss in Macroeconomics, Chapter 15, Section 15.4 (Economics, Chapter 25, Section 25.4) and in Money, Banking, and the Financial System, Chapter 13, Section 13.1, Congress established the Fed to serve as a lender of last resort making loans to banks that were having temporary liquidity problems because depositors were withdrawing more funds than the bank could meet from its own cash holdings. Discount loans were intended to be short term, often overnight, and were to be made only to healthy banks that were solvent—the value of the banks’ assets were greater than the value of their liabilities—and that could pledge short-term business loans (called at the time “real bills”) as collateral.
Today, healthy banks with temporary liquidity needs can request a loan through the Fed’s discount window (an antique term dating from the early years of the system when the loans were literally made at a specific window at each regional Fed bank) from the Fed’s primary credit facility, or standing lending facility. Over the years, the importance of discount loans declined. The establishment of the Federal Deposit Insurance Corporation (FDIC) in 1934 reassured households and businesses that held deposits below the insurance limit that they did not need to withdraw their deposits at the first sign of trouble with their local bank. As a result, after the establishment of the FDIC few banks experienced runs.
In addition, the development of the federal funds market gave banks another source of short-term credit. Because the federal funds rate is typically lower than the interest rate (the discount rate) that the Fed charges on discount loans, most banks find borrowing in the federal funds market preferrable to borrowing at the Fed’s discount window. As banks’ use of discount loans declined, many banks were afraid that going to the discount window would be seen by depositors and investors as a sign the bank was in financial trouble. This stigma was an additional reason that most banks avoided borrowing at the discount window.
As the figure shows, in the years leading up to the Great Financial Crisis, the volume of discount loans had dwindled to very low levels. After a surge in discount borrowing following the failure of the Lehman Brothers investment bank in September 2008, discount borrowing gradually fell back to low levels. A smaller surge in discount borrowing occurred in the spring of 2020 at the beginning of the Covid–19 pandemic in the United States. Discount borrowing quickly declined during the following months.
The failure of Silicon Valley Bank (SVB) on March 10 and Signature Bank on March 12 pushed the volume of discount loans to record levels, as shown by the vertical line at the far right of the figure. The values in the figure include three types of loans:
Primary credit, which are traditional discount loans.
Other credit extensions, which are loans from Federal Reserve District Banks to the FDIC to fund so-called bridge banks established by the FDIC to operate SVB and Signature Bank until either purchasers can be found for the banks or their assets can be sold and the banks permanently closed.
Loans under the Fed’s Bank Term Funding Program, which are loans the Fed has made under this new facility established on March 12. The loans are secured by the borrowing banks’ holdings of Treasury and mortgage-backed securities.
The data underlying the figure come from the Fed’s H.4.1 statistical release, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” which can be found here.
Which banks are doing this borrowing? To avoid stigma, the Fed doesn’t release the names of the banks for two years, but, presumably, regional banks, such as First Republic Bank, that have been experiencing substantial depositor withdrawals are doing so. (First Republic has publicly announced that it is borrowing from the Fed.) The amounts borrowed are so large, however, that it appears that a significant number of banks are either in need of liquidity or are preparing to be able to meet waves of deposit withdrawals should they occur.
Whether the banking crisis that began with the failure of SVB is largely over is unclear at this point, but the managers of some banks are preparing in case the crisis continues.
Sheila Bair served as chair of the Federal Deposit Insurance Corporation (FDIC) from 2006 to 2011. This week, she was interviewed on the Wall Street Journal’s “Free Expression” podcast. She states that she had still been chair of the FDIC she would have been against the decision on Sunday, March 12, 2023, to declare that Silicon Valley Bank (SVB) as being systemically important. The declaration formed the basis of the decision by the FDIC, the Federal Rerserve, and the Treasure that SVB’s customers with deposits above the normal $250,000 insurance limit would be allowed to withdraw all their funds beginning Monday morning.
She argues that it would have been better to have followed the FDIC’s usual procedure of allowing insured depositors to withdraw their funds and declaring a “dividend” that would have allowed withdrawal of 50 percent of uninsured deposits. As SVB’s assets were sold, uninsured depositors would be able to make additional withdrawals, although because the value of the assets would likely be less than the value of the deposits, uninsured depositors would suffer some losses.
She believes that SVB’s problems were the result of poor management and she doubts that the bank’s uninsured depositors suffering losses would have led to runs on the deposits of other regional banks.
The wide-ranging interview is well worth listening to in full. The podcast can be found here.
Wall Street during the Panic of 1907. (Photo from the New York Public Library via Federal Reserve History.)
The collapse of Silicon Valley Bank (SVB) on Friday, March 10 highlighted two potential sources of instability in the U.S. commercial banking system: (1) The risk that depositors with more than the Federal Deposit Insurance Corporation (FDIC) insurance deposit limit of $250,000 in their accounts may withdraw their deposits leading to liquidity problems in the banks experiencing the withdrawals; and (2) The losses many banks have taken on their Treasury and mortgage-backed securities as interest rates have risen. (We discuss SVB in this post and banks’ losses on their security holdings in this post.) The sources of instability are related in that the losses on their security holdings may cause banks to have difficulty obtaining the funds to meet deposit withdrawals.
Note that, although the FDIC, the Federal Reserve, and the Treasury guaranteed all deposits in SVB and in Signature Bank (which was closed on Sunday, March 1), the FDIC insurance limit of $250,000 per deposit, per bank remains in effect for all other banks.
The banks most at risk for large deposit outflows are the regional banks. In terms of size, regional banks stand intermediate between the large national banks, like JP Morgan Chase and Bank of America, and small community banks. Depositors seem reassured that the large national banks have sufficient capital to withstand deposit outflows. The small community banks mainly hold retail deposits—deposits made by households and local businesses—that are typically below the $250,000 FDIC deposit limit.
On Thursday, March 16, First Republic Bank seemed to be the regional bank at most risk. Over the previous several days it experienced an outflow of billions of dollars in deposits. The Fed’s new Bank Term Funding Program (BTFP) made it possible for First Republic to borrow against its Treasury and mortgage-backed securities holdings—rather than selling the securities—to meet deposit outflows. Investors were not reassured, however, that using the BFTP would be sufficient to meet First Republic’s funding needs. The bank’s stock fell sharply on Wednesday and again on Thursday morning. S&P reduced its rating of the bank’s bonds to junk status. (We discuss bond ratings in an Apply the Concept in Macroeconomics, Chapter 6, Section 6.2 (Economics, Chapter 8, Section 8.2) and, at greater length, in Money, Banking, and the Financial System, Chapter 5, Section 5.1.)
According to an article in the Wall Street Journal, on Thursday morning: “The biggest banks in the U.S. are discussing a joint rescue of First Republic Bank that could include a sizable capital infusion to shore up the beleaguered lender .… The rescue would be an extraordinary effort to protect the entire banking system from widespread panic by turning First Republic into a firewall.” Among the banks participating in the plan are JP Morgan Chase, Well Fargo, Citigroup, and Bank of America. Because many large depositors had been switching their deposits from regional banks like First Republic to large banks, according to the article, the resuce plan would include the large banks making deposits in First Republic, thereby indirectly returning some of the deposits that First Republic had lost.
The banks involved in the rescue plan were apparently consulting with the Federal Reserve and the Treasury. Because this plan involved private banks attempting to help another private bank deal with deposit outflows, it was reminiscent of the actions of the bank clearing houses that operated in major cities before the Federal Reserve began operations in 1914.
Under this system, all the largest banks in a city were typically members of the clearing house, as were many midsize banks. The clearing houses had the ability to advance funds to meet the short-run liquidity needs of members. In effect, the clearing houses were operating in a way similar to the Fed’s extension of discount loans. Although the clearing houses were unable to stop bank panics, there is evidence that they were helpful in reducing deposit outflows from member banks. The famous financier J. P. Morgan was the most influential figure in the New York Clearing House during the early 1900s. This article on the Panic of 1907 discusses the role of Morgan and the New York Clearing House. A discussion of how the actions of the New York Clearing House compare with the actions of a government central bank, like the Fed, can be found here.
Join authors Glenn Hubbard and Tony O’Brien as they review the collapse of Silicon Valley Bank (SVB) in the context of a classic bank run. What lessons can be learned to avoid other bank collapses in this unchartered economic territory? Will this become a contagion? Or, is it simply an example of a bank searching for additional return in an uncertain economic world? Our discussion covers these points but you can also check for updates on our blog post that can be found HERE.
Rumors spread about the financial state of a bank. Some depositors begin to withdraw funds from their accounts. Suddenly a wave of withdrawals occurs and regulators step in and close the bank. A description of a run on a bank in New York City in the fall of 1930? No. This happened to Silicon Valley Bank, headquartered in Santa Clara, California and the sixteenth largest bank in the United States, on Friday, March 10, 2023.
Background on Bank Runs
In Macroeconomics, Chapter 14, Section 14.4 (Economics, Chapter 24, Section 24.4) we describe the basic reasons why a run on a bank may occur. We describe bank runs in greater detail in Money, Banking, and the Financial System, Chapter 12. We reproduce here a key paragraph on the underlying fragility of commercial banking from Chapter 12 of the money and banking text:
The basic activities of commercial banks are to accept short-term deposits, such as checking account deposits, and use the funds to make loans—including car loans, mortgages, and business loans—and to buy long-term securities, such as municipal bonds. In other words, banks borrow short term from depositors and lend, often long term, to households, firms, and governments. As a result, banks have a maturity mismatch because the maturity of their liabilities—primarily deposits—is much shorter than the maturity of their assets—primarily loans and securities. Banks are relatively illiquid because depositors can demand their money back at any time, while banks may have difficulty selling the loans in which they have invested depositors’ money. Banks, therefore, face liquidity risk because they can have difficulty meeting their depositors’ demands to withdraw their money. If more depositors ask to withdraw their money than a bank has money on hand, the bank has to borrow money, usually from other banks. If banks are unable to borrow to meet deposit withdrawals, then they have to sell assets to raise the funds. If a bank has made loans and bought securities that have declined in value, the bank may be insolvent, which means that the value of its assets is less than the value of its liabilities, so its net worth, or capital, is negative. An insolvent bank may be unable to meet its obligations to pay off its depositors.
The Founding of the Fed and the Establishment of the FDIC as a Response to Bank Runs
The instability of the banking system led to a number of financial crises during the 1800s and early 1900s, culminating in the Panic of 1907. Congress responded by passing the Federal Reserve Act in 1913, establishing the Federal Reserve System. The Fed was given the role of lender of last resort, making discount loans to banks that were experiencing deposit runs but that remained solvent. The failure of the Fed to stop the bank panics of the early 1930s led Congress to establish the Federal Deposit Insurance Corporation (FDIC) to ensure deposits in commercial banks, originally up to a limit of $2,500 per deposit, per bank. The current limit is $250,000.
Deposit insurance reduced the likelihood of runs but increased moral hazard in the banking system by eliminating the incentive insured depositors had to monitor the actions of bank managers. In principle, bank managers still have an incentive to avoid making risky loans and other investments for fear of withdrawals by households and firms with deposits that exceed the dollar deposit limit.
Contagion, Moral Hazard, and the Too-Big-to-Fail Policy
But if these depositors fail to monitor risk taking by bank managers or if a bank’s loans and investments decline in price even though they weren’t excessively risky at the time they were made, the FDIC and the Fed face a dilemma. Allowing banks to fail and large depositors to be only partially paid back may set off a process of contagion that results in runs spreading to other banks. Problems in the banking system can affect the wider economy by making it more difficult for households and firms that depend on bank loans to finance their spending. (We discuss the process of contagion in this post on the Diamond-Dybvig model.)
The Fed and the FDIC can stop the process of contagion if they are willing to ensure that large depositors don’t suffer losses. One mechanism to achieve this result is facilitating a merger between an insolvent bank and another bank that agrees to assume responsibility for meeting depositors withdrawals from the insolvent bank. But stopping contagion in this manner with no depositors suffering losses can be interpreted as amounting to deposit insurance having no dollar limit. The result is a further increase in moral hazard in the banking system. When the federal government does not allow large financial firms to fail for fear of damaging the financial system, it is said to be following a too-big-to-fail policy.
Silicon Valley Bank and VCs
Runs on commercial banks have been rare in recent decades, which is why the run on Silicon Valley Bank (SVB) took many people by surprise. As its name indicates, SVB is located in the heart of California’s Silicon Valley and the bank played an important role in the financing of many startups in the area. As such, SVB provided banking services to many venture capital (VC) firms. As we note in Chapter 9, Section 9.2 of the money and banking text, venture capital firms play an important role in providing funding to startup firms:
VCs such as Sequoia Capital, Accel, and Andreessen Horowitz raise funds from investors and invest in small startup firms, often in high-technology industries. In recent years, VCs have raised large amounts from institutional investors, such as pension funds and university endowments. A VC frequently takes a large ownership stake in a startup firm, often placing its own employees on the board of directors or even having them serve as managers. These steps can reduce principal–agent problems because the VC has a greater ability to closely monitor the managers of the firm it’s investing in. The firm’s managers are likely to be attentive to the wishes of a large investor because having a large investor sell its stake in the firm may make it difficult to raise funds from new investors. In addition, a VC avoids the free-rider problem when investing in a firm that is not publicly traded because other investors cannot copy the VC’s investment strategy.
An article on bloomberg.com summarized SVB’s role in Silicon Valley. SVB is
the single most critical financial institution for the nascent tech scene, serving half of all venture-backed companies in the US and 44% of the venture-backed technology and health-care companies that went public last year. And its offerings were vast — ranging from standard checking accounts, to VC investment, to loans, to currency risk management.
Note from this description that SVB acted as a VC—that is, it made investments in startup firms—as well as engaging in conventional commercial banking activities, such as making loans and accepting deposits. The CEO of one startup was quoted in an article in the Wall Street Journal as saying, “For startups, all roads lead to Silicon Valley Bank.” (The Wall Street Journal article describing the run on SVB can be found here. A subscription may be required.)
SVB’s Vulnerability to a Run
As with any commercial bank, the bulk of SVB’s liabilities were short-term deposits whereas the bulk of its assets were long-term loans and other investments. We’ve discussed above that this maturity mismatch means that SVB—like other commercial banks—was vulnerable to a run if depositors withdraw their funds. We’ve also seen that in practice bank runs are very rare in the United States. Why then did SVB experience a run? SVB was particularly vulnerable to a run for two related reasons:
1. Its deposits are more concentrated than is true of a typical bank. Many startups and VCs maintain large checking account balances with SVB. According to the Wall Street Journal, at the end of 2022, SVB had $157 billion in deposits, the bulk of which were in just 37,000 accounts. Startups often initially generate little or no revenue and rely on VC funding to meet their expenses. Most Silicon Valley VCs advised the startups they were invested in to establish checking accounts with SVB.
2. Accordingly, the bulk of the value of deposits at SVB was greater than the $250,000 FDIC insurance limit. Apparently 93 percent to 97 percent of deposits were above the deposit limit as opposed to about 50 percent for most commercial banks.
Economics writer Noah Smith notes that SVB required that startups it was lending to keep their deposits with SVB as a condition for receiving a loan. (Smith’s discussion of SVB can be found on his Substack blog here. A subscription may be required.)
The Reasons for the Run on SVB
When the Fed began increasing its target for the federal funds rate in March 2022 in response to a sharp increase in inflation, longer term interest rates, including interest rates on U.S. Treasury securities, also increased. For example the interest rate on the 10-year Treasury note increased from less than 2 percent in March 2022 to more than 4 percent in March 2023. The interest rate on the 2-year Treasury note increased even more, from 1.5 percent in March 2022 to around 5 percent in March 2023.
As we discuss in the appendix to Macroeconomics, Chapter 6 (Economics, Chapter 8) and in greater detail in Money, Banking, and the Financial System, Chapter 3, the price of a bond or other security equals the present value of the payments the owner of the security will receive. When market interest rates rise, as happened during 2022 and early 2023, the value of the payments received on existing securities—and therefore the prices of these securities—fall. Treasury securities are free from default risk, which is the risk that the Treasury won’t make the interest and principal payments on the security, but are subject to interest-rate risk, which is the risk that the price of security will decrease as market interest rates rise.
As interest rates rose, the value of bonds and other long-term assets that SVB owned fell. The price of an asset on the balance sheet of a firm is said to be marked to market if the price is adjusted to reflect fluctuations in the asset’s market price. However, banking law allows a bank to keep constant the prices of bonds on its balance sheets if it intends to hold the bonds until they mature, at which point the bank will receive a payment equal to the principal of the bond. But if a bank needs to sell bonds, perhaps to meet its liquidity needs as depositors make withdrawals, then the losses on the bonds have to be reflected on the bank’s balance sheet.
SVB’s problems began on Wednesday, March 8 when it surprised Wall Street analysts and the bank’s Silicon Valley clients by announcing that to raise funds it had sold $21 billion in securities at a loss of $1.8 billion. It also announced that it was selling stock to raise additional funds. (SVB’s announcement can be found here.) SVB’s CEO also announced that the bank would borrow an additional $15 billion. Although the CEO stated that the bank was solvent, as an article on fortune.com put it, “Investors didn’t buy it.” In addition to the news that SVB had suffered a loss on its bond sales and had to raise funds, some analysts raised the further concern that the downturn in the technology sector meant that some of the firms that SVB had made loans to might default on the loans.
Problems for SVB compounded the next day, Thursday, March 9, when Peter Theil, a co-founder of PayPal and Founders Fund, a leading VC, advised firms Founders Fund was invested in to withdraw their deposits from SVB. Other VCs began to pull their money from SVB and advised their firms to do the same and a classic bank run was on. Because commercial banks lack the funds to pay off a significant fraction of their depositors over a short period of time, in a run, depositors with funds above the $250,000 deposit insurance limit know that they need to withdraw their funds before other depositors do and the bank is forced to close. This fact makes it difficult for a bank to stop a run once it gets started.
According to an article in the Wall Street Journal, by the end of business on Thursday, depositors had attempted to withdraw $42 billion from SVB. The FDIC took control of SVB the next day, Friday, March 10, before the bank could open for business.
The Government Response to the Collapse of SVB
The FDIC generally handles bank failures in one of two ways: (1) It closes the bank and pays off depositors, or (2) it purchases and assumes control of the bank while finding another bank that is willing to purchase the failed bank. If the FDIC closes a bank, it pays off the insured depositors immediately, using the bank’s assets. If those funds are insufficient, the FDIC makes up the difference from its insurance reserves, which come from payments insured banks make to the FDIC. After the FDIC has compensated insured depositors, any remaining funds are paid to uninsured depositors.
As we write this on Sunday, March 12, leaders of the Fed, the FDIC, and the Treasury Department, were considering what steps to take to avoid a process of contagion that would cause the failure of SVB to lead to deposit withdrawals and potential failures of other banks—in other words, a bank panic like the one that crippled the U.S. economy in the early 1930s, worsening the severity of the Great Depression. These agencies hoped to find another bank that would purchase SVB and assume responsibility for meeting further deposit withdrawals.
Another possibility was that the FDIC would declare that closing SVB, selling the bank’s assets, and forcing depositors above the $250,000 deposit limit to suffer losses would pose a systemic risk to the financial system. In that circumstance, the FDIC could provide insurance to all depositors however large their deposits might be. As discussed earlier, this approach would increase moral hazard in the banking system because it would, in effect, waive the limit on deposit insurance. Although the waiver would apply directly only to this particular case, large depositors in other banks might conclude that if their bank failed, the FDIC would waive the deposit limit again. Under current law, the FDIC could only announce they were waiving the deposit limit if two-thirds of the FDIC’s Board of Directors, two-thirds of the Fed’s Board of Governors, and Treasury Secretary Janet Yellen agreed that failure of SVB would pose a systemic risk to the financial system.
According to an article on wsj.com posted at 4 pm on Sunday afternoon, bank regulators were conducting an auction for SVB in the hopes that a buyer could be found that would assume responsibility for the bank’s uninsured deposits. [Update evening of Monday March 13: The Sunday auction failed when no U.S. banks entered a bid. Late Monday, the FDIC was planning on holding another auction, with potentially better terms available for the acquiring bank.]
Update: At 6:15 pm Sunday, the Treasury, the Fed, and the FDIC issued a statement (you can read it here). As we noted might occur above, by invoking a situation of systemic risk, the FDIC was authorized to allow all depositors–including those with funds above the deposit limit of $250,000–to access their funds on Monday morning. Here is an excerpt from the statement:
“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.”
[Update Monday morning March 13] As we discussed above, one of the problems SVB faced was a decline in the prices of its bond holdings. As a result, when it sold bonds to help meet deposit outflows, it suffered a $2.1 billion loss. Most commercial banks have invested some of their deposits in Treasury bonds and so potentially face the same problem of having to suffer losses if they need to sell the bonds to meet deposit outflows.
To deal with this issue, Sunday night the Fed announced that it was establishing the Bank Term Funding Program (BTFP). Banks and other depository institutions, such as savings and loans and credit unions, can use the BTFP to borrow against their holdings of Treasury and mortgage-backed securities and agency debt. (Agency debt consists of bonds issued by any federal government agency other than the U.S. Treasury. Most agency debt is bonds issued by the Government Sponsored Agencies (GSEs) involved in the mortgage market: Federal National Mortgage Association (Fannie Mae), Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage (Freddie Mac).) The Fed explained its reasons for setting up the BTFP: “The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.” You can read the Fed’s statement here.
On Sunday, Signature Bank was closed by New York state banking officials and the FDIC. As with SVB, the Fed, FDIC, and Treasury announced that all depositors, including those whose deposits were above the $250,000 deposit limit, would be able to withdraw the full amount of their deposits.
Shareholders in SVB and Signature Bank lost their investments when the FDIC took control of the banks. On Monday morning, investors were selling shares of a number of regional banks who might also face runs, fearing that their investments would be lost if the FDIC were to seize these banks.
President Biden, speaking from the White House, attempted to reassure the public that the banking system was safe. He stated that he would ask Congress to explore changes in banking regulations to reduce the likelihood of future bank failures.
During the recovery from the Covid–19 pandemic, inflation as measured by the personal consumption expenditures (PCE) price index, first rose above the Federal Reserve’s target annual inflation rate of 2 percent in March 2021. Many economists inside and outside of the Fed believed the increase in inflation would be transitory because it was thought to be mainly the result of supply chain problems and an initial burst of spending as business lockdowns were ended or mitigated in most areas.
Accordingly, the Federal Open Market Committee (FOMC) kept its target for the federal funds rate at effectively zero (a range of 0 to 0.25 percent) until March 2022 and continued its quantitative easing (QE) program of buying long-term Treasury bonds and mortgage-backed securities (MBS) until that same month.
As the following figure shows, by March 2022 inflation had been well above the FOMC’s target for a year. The Fed responded by raising its target for the federal funds rate and switched from QE to quantitative tightening (QT). Although some supply chain problems were still contributing to the high inflation rate during the spring of 2022, the main driver appeared to be very expansionary monetary and fiscal policies. (This blog post from May 2021 has links to contributions to the debate over macro policy at the time. Glenn’s interview that month with the Financial Times can be found here. In November 2022, Glenn argued that overly expansionary fiscal policy was the main driver of inflation in this op-ed in the Financial Times (subscription or registration may be required).We discuss inconsistencies in the Fed’s forecasts of unemployment and inflation here. And in this post we discuss the question of whether the Fed made a mistake in not attempting to preempt inflation before it accelerated.)
Since March 2022, the FOMC has raised its target for the federal funds rate multiple times. In February 2023, the target was a range of 4.50 to 4.75 percent. Longer-term interest rates have also increased. In particular, the average interest rate on residential mortgage loans increased from 3 percent in March 2022 to 7 percent in November 2022, before falling back to around 6 percent in February 2023. In the fall of 2022, there was optimism among some economists that the Fed had succeeded in slowing the economy enough to put inflation on a path back to its 2 percent target. Although many economists had expected that inflation would only return to the target if the U.S. economy experienced a recession—labeled a hard landing—the probability that inflation could be reduced without a recession—labeled a soft landing—appeared to be increasing.
Economic data for January 2023 made a soft landing seem less likely. Consumer spending remained above its trend from before the pandemic, employment increases were unexpectedly high, and inflation reversed its downward trend. A continuation of low rates of unemployment and high rates of inflation wasn’t consistent with either a hard landing or a soft landing. Some observers, particularly in Wall Street financial firms, began describing the situation as no landing. But given the Fed’s strong commitment to returning to its 2 percent target, the no landing scenario couldn’t persist indefinitely.
Many investors had anticipated that the FOMC would end its increases in the federal funds target by mid-2023 and would have made one or more cuts to the target by the end of the year, but that outcome now seems unlikely. The FOMC had increased the federal funds target by only 0.25 percent at its February meeting but many economists now expected that it would announce a 0.50 percent increase at its next meeting on March 21 and 22. Unfortunately, the odds of a hard landing seem to be increasing.
A couple of notes: Although there are multiple ways of measuring inflation, the percentage increase in the PCE is the formal way in which the FOMC determines whether it is hitting its inflation target. To judge what the underlying inflation is—in other words, the inflation rate likely to persist in at least the near future—many economists look at core inflation. In the earlier figure we show movements in core inflation as measured by the PCE excluding prices of food and energy. Note that over the period shown PCE and core PCE follow the same pattern, although core PCE inflation begins to moderate earlier than does core PCE.
Some economists use other adjustments to PCE or to the consumer price index (CPI) in an attempt to better measure underlying inflation. For instance, housing rents and new and used car prices have been particularly volatile since early 2020, so some economists calculate PCE or CPI excluding those prices, as well as food and energy prices. As we discuss in this blog post from last September some economists prefer median CPI as the best measure of underlying inflation. (We discuss some of the alternative ways of measuring inflation in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.) Nearly all these alternative measures of inflation indicated that the moderation in inflation that began in the summer of 2022 had ended in January 2023. So, choosing among measures of underlying inflation wasn’t critical to understanding the current path of inflation.
Finally, the inflation, employment, and output measures that in January seemed to show that the U.S. economy was still in a strong expansion and that the inflation rate may have ticked up are all seasonally adjusted. Seasonal adjustment factors are applied to the raw (unadjusted) data to account for regular seasonal fluctuations in the series. For instance, unadjusted employment declined in January as measured by both the household and establishment series. Applying the seasonal adjustment factors to the data resulted in the actual decline in employment from December to January turning into an adjusted increase. In other words, employment declined by less than it typically does, so on a seasonally adjusted basis, the Bureau of Labor Statistics reported that it had increased. Seasonal adjustments for the holiday season may be distorted, however, because the 2020–2021 and 2021–2022 holiday seasons occurred during upsurges in Covid. Whether the reported data for January 2023 will be subject to significant revisions when the seasonal adjustments factors are subsequently revised remains to be seen. The latest BLS employment report, showing seasonally adjusted and not seasonally adjusted data, can be found here.
Join author Glenn Hubbard & Tony O’Brien in their first Sprint 2023 podcast where they revisit inflation as the major topic facing our country, our economy, and our classrooms. Glenn & Tony discuss the Federal Reserve response and the outlook for the economy. While rates have continued to move up, is a soft-landing still possible?
Ben Bernanke (Photo from the Brookings Institution.)Douglas Diamond (Photo from Reuters.)Philip Dybvig (Photo from Washington University.)
Former Federal Reserve Chair Ben Bernanke (now a Distinguished Fellow in Residence at the Brookings Institution in Washington, DC), Douglas Diamond of the University of Chicago, and Philip Dybvig of Washington University in St. Louis shared the 2022 Nobel Prize in Economics (formally called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel). The prize of 10 million Swedish kronor (about 8.85 million U.S. dollars) was awarded for “significantly [improving] our understanding of the role of banks in the economy, particularly during financial crises.” (The press release from the Nobel committee can be read here.)
In paper published in the American Economic Review in 1983, Bernanke provided an influential interpretation of the role the bank panics of the early 1930s played in worsening the severity of the Great Depression. As we discuss in Macroeconomics, Chapter 14, Section 14.3 (Economics, Chapter 24, Section 24.3), by taking deposits and making loans banks play an important in the money supply process. Milton Friedman and Anna Schwartz in A Monetary History of the United States, 1867-1960, Chapter 7, argued that the bank panics of the early 1930s caused a decline in real GDP and employment largely through the mechanism of reducing the money supply.
Bernanke demonstrated that the bank failures affected output and employment in another important way. As we discuss in Macroeconomics, Chapter 6, Section 6.2 and Chapter 14, Section 14.4 (Economics, Chapter 8, Section 8.2 and Chapter 24, Section 24.4) banks are financial intermediaries who engage in indirect finance. Banks accept deposits and use the funds to make loans to households and firms. Households and most firms can’t raise funds through direct finance by selling bonds or stocks to individual investors because investors don’t have enough information about households or all but the largest firms to know whether these borrowers will repay the funds. Banks get around this information problemby specializing in gathering information on households and firms that allow them to gauge how likely a borrower is to default, or stop paying, on a loan.
Because of the special role banks have in providing credit to households and firms that have difficulty borrowing elsewhere, Bernanke argued that the bank panics of the early 1930s, during which more than 5,000 banks in the United States went out of business, not only caused a reduction in the money supply but restricted the ability of households and firms to borrow. As a result, households and firms decreased their spending, which increased the severity of the Great Depression.
In a 1983 paper published in the Journal of Political Economy, Diamond and Dybvig presented what came to be known as the Diamond and Dybvig model of the economic role of banks. This model, along with later research by Diamond, provided economists with a better understanding of the potential instability of banking. Diamond and Dybvig note that banking involves transforming long-run, illiquid assets—loans—into short-run, liquid assets—deposits. Recall that liquidity is the ease with which an asset can be sold. Households and firms want the loans they receive from a bank to be illiquid in the sense that they don’t want the bank to be able to demand that the funds borrowed be repaid, except on a set schedule. Someone receiving a mortgage loan to buy a house wouldn’t want the bank to be able to insist on being paid back any time the bank chose. But households and firms also want the assets they hold to be liquid so that they can quickly convert the assets into money if they need the funds. By taking in deposits and using the funds to make loans, banks provide a service to households and firms by providing both a source of long-run credit and a source of short-term assets.
But Diamond and Dybvig note that because banks hold long-terms assets that can’t easily be sold, if a large number of people attempt simultaneously to withdraw their deposits, the banks lack the funds to meet these withdrawals. The result is a run on a bank as depositors become aware that unless they quickly withdraw their deposits, they may not receive their funds for a considerable time. If the bank is insolvent—the value of its loans and other assets is less than the value of its deposits and other liabilities—the bank may fail and some households and firms will never receive the full value of their deposits. In the Diamond and Dybvig model, if depositors expect that other depositors will not withdraw their funds, the system can be stable because banks won’t experience runs. But because banks know more about the value of their assets and liabilities than depositors do, depositors may have trouble distinguishing solvent banks from insolvent banks. As a result of this information problem, households and firms may decide to withdraw their deposits even from solvent banks. Households and firms may withdraw their deposits from a bank even if they know with certainty that the bank is solvent if they expect that other households and firms—who may lack this knowledge—will withdraw their deposits. The result will be a bank panic, in which many banks simultaneously experience a bank run.
With many banks closing or refusing to make new loans in order to conserve funds, households and firms that depend on bank loans will be forced to reduce their spending. As a result, production and employment will decline. Falling production and employment may cause more borrowers to stop paying on their loans, which may cause more banks to be insolvent, leading to further runs, and so on. We illustrate this process in Figure 14.3.
Diamond and Dybvig note that a system of deposit insurance—adopted in the United States when Congress established the Federal Deposit Insurance Corporation (FDIC) in 1934—or a central bank acting as a lender of last resort to banks experiencing runs are necessary to stabilize the banking system. When Congress established the Federal Reserve System in 1914, it gave the Fed the ability to act as a lender of last resort by making discount loans to banks that were solvent but experiencing temporary liquidity problems as a result of deposit withdrawals.
During the Global Financial Crisis that began in 2007 and accelerated following the failure of the Lehman Brothers investment bank in September 2008, it became clear that the financial firms in the shadow banking system could also be subject to runs because, like commercial banks, shadow banks borrow short term to financial long term investments. Included in the shadow banking system are money market mutual funds, investment banks, and insurance companies. By 2008 the size of the shadow banking system had grown substantially relative to the commercial banking system. The shadow banking system turned out to be more fragile than the commercial banking system because those lending to shadow banks by, for instance, buying money market mutual fund shares, do not receive government insurance like bank depositors receive from the FDIC and because prior to 2008 the Fed did not act as a lender of last resort to shadow banks.
Bernanke believes that his study of financial problems the U.S. experienced during the Great Depression helped him as Fed chair to deal with the Global Financial Crisis. In particular, Bernanke concluded from his research that in the early 1930s the Fed had committed a major error in failing to act more vigorously as a lender of last resort to commercial banks. The result was severe problems in the U.S. financial system that substantially worsened the length and severity of the Great Depression. During the financial crisis, under Bernanke’s leadership, the Fed established several lending facilities that allowed the Fed to extend its role as a lender of last resort to parts of the shadow banking system. (In 2020, the Fed under the leadership of Chair Jerome Powell revived and extended these lending facilities.) Bernanke is rare among economists awarded the Nobel Prize in having had the opportunity to implement lessons from his academic research in economic policymaking at the highest level. (Bernanke discusses the relationship between his research and his policymaking in his memoir. A more complete discussion of the financial crises of the 1930s, 2007-2009, and 2020 appears in Chapter 14 of our textbook Money, Banking, and the Financial System, Fourth Edition.)
We should note that Bernanke’s actions at the Fed have been subject to criticism by some economists and policymakers. As a member of the Fed’s Board of Governors beginning in 2002 and then as Fed chair beginning in 2006, Bernanke, like other members of the Fed and most economists, was slow to recognize the problems in the shadow banking system and, particularly, the problems caused by the rapid increase in housing prices and increasing number of mortgages being granted to borrowers who had either poor credit histories or who made small down payments. Some economists and policymakers also argue that Bernanke’s actions during the financial crisis took the Fed beyond the narrow role of stabilizing the commercial banking system spelled out by Congress in the Federal Reserve Act and may have undermined Fed independence. They also argue that by broadening the Fed’s role as a lender of last resort to include shadow banks, Bernanke may have increased the extent of moral hazard in the financial system.
Finally, Laurence Ball of Johns Hopkins University argues that the worst of the financial crisis could have been averted if Bernanke had acted to save the Lehman Brothers investment bank from failing by making loans to Lehman. Bernanke has argued that the Fed couldn’t legally make loans to Lehman because the firm was insolvent but Ball argues that, in fact, the firm was solvent. Decades later, economists continue to debate whether the Fed’s actions in allowing the Bank of United States to fail in 1930 were appropriate and the debate over the Fed’s actions with respect to Lehman may well last as long. (A working paper version of Ball’s argument can be found here. He later extended his argument in a book. Bernanke’s account of his actions during the failure of Lehman Brothers can be found in his memoir cited earlier.)
Sources: Paul Hannon, “Nobel Prize in Economics Winners Include Former Fed Chair Ben Bernanke,” Wall Street Journal, October 10, 2022; David Keyton, Frank Jordans, and Paul Wiseman, “Former Fed Chair Bernanke Shares Nobel for Research on Banks,” apnews.com, October 10, 2022; and Greg Ip, “Most Nobel Laureates Develop Theories; Ben Bernanke Put His Into Practice,” Wall Street Journal, October 10, 2022.
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