Low sensitivity to interest rates was always going to be the Fed’s Achilles heel because its key policy tool is less effective at restraining demand in a timely manner.
It also increases the possibility that monetary policy lags have lengthened, increasing the uncertainty over the level at which interest rates become restrictive.
With every step up in interest rates, the risk that something within the financial system breaks has only grown more plausible. A decade of ultra-low interest rates was also likely to have led to investor complacency and mispricing of long-term risk.
Over the past year, as rates continued to march higher, there has been gathering evidence that risks were building up within the financial system.
The implosion of the crypto industry following the collapse of a leading exchange, FTX, was the first casualty. Liz Truss’s ill-fated "mini"-Budget was another.
The recent collapse of Silicon Valley Bank, Signature Bank and Credit Suisse are the most dramatic casualties of the central bankers’ quest for price stability. Given their pole position in the heart of the financial system, central bankers had little choice but to move decisively and aggressively.
In the US, regulators not only guaranteed all deposits (including uninsured) of the banks in receivership, but they also launched a new temporary lending programme that allows banks to borrow from the Fed using the par value of treasury bonds as collateral.
Given the large unrealised losses across the banking system associated with treasury bond holdings, such a programme will likely be helpful in arresting the near-term financial panic. However, such a move is also highly controversial as it implicitly removes the downside risks from holding bonds.
Central banking, till now, has always followed Bagehot’s dictum: lend freely, at a penalty rate against good collateral.
The latest Fed programme goes above and beyond this. By lending at par value, the Fed has removed not only the interest rate risk, but also market discipline associated with holding treasury bonds.
Even so, financial conditions are likely to continue tightening and tip the economy into a recession for two main reasons.
First, as inflation continues to head lower, real interest rates will mechanically move higher. By the second half of the year, real interest rates are likely to be between 1 per cent and 2 per cent – a level that typically leads to a significant slowdown in demand.
