If you enjoy our content and would like to support our work, we make additional content available for our donors. If you’re interested in gaining access to our Premium Donor distribution, please feel free to reach out to us here for more information.
Summary
The tension between the Fed’s financial stability and inflation priorities runs deeper than many have appreciated. In the 2010s financial stability considerations within monetary policy were primarily framed as though in tension with central bank efforts to promote employment and economic activity, but the real dilemma is between the financial stability and inflation mandates. Their tools, specifically interest rates, are wielded to intentionally raise the cost of capital that firms face. While the financial stability benefits of hikes have always been more speculative and the disinflationary benefits of hikes more aspirational and attenuated, the financial stability costs are direct.
Over the past two weeks, banks have seen a very dramatic increase in their cost of equity capital. By tightening capital market conditions for the sake of lower inflation, the Fed's policies (intentionally) make it harder for all firms, including banks, to raise capital. It's worth being clear that this strategy inherently raises financial stability threats.
Discussion
Banks rely on resilient sources of equity and debt funding to stave off solvency and stability risks. As we saw in the global financial crisis, the ability to raise capital from these sources is critical to longer term stability. Public sector efforts (TARP) and private sector efforts to raise equity capital in the fall of 2008 played a critical role in stabilizing bank balance sheets. But as bank stocks (or their bond yields) have shown over the past two weeks, there has been an abrupt surge in the cost of raising such capital. Ideally banks facing fragility issues have already raised sufficient capital to weather these challenges, and it likely is still true that the system as a whole remains well-capitalized. But for banking firms closer to the point of vulnerability, additional sources of stable funding should—from a financial stability perspective—be welcomed.
The Fed's goal has been to reduce economic activity by raising interest rates specifically to tighten financial conditions. The Fed’s campaign to raise its benchmark interest rate has been motivated by a desire to see broader financial conditions tighten for businesses and households. By financial conditions, we (and the Fed) mean a broad set of asset prices that shape behavior within the real economy (spending, hiring, investment, pricing). To the extent that financial conditions have eased and promoted more spending even as the Fed hiked, the Fed has made it clear they are willing to hike more as a result. The trouble is that Fed-induced financial conditions tightening involves pushing up the cost of (equity) capital for banks.
The US financial system is oriented around capital markets–specifically the cost of debt and equity capital that businesses face. Even if no financing activity takes place and even if businesses are not publicly listed, CEOs and CFOs still look to public markets for key signals. Capital and operating budgets tend to be set in a manner that delivers a sufficient return on equity to shareholders. Those decisions filter into labor market and fixed investment dynamics as a result.
Financial stability arguments usually take on a hawkish cast in discussions about interest rate policy. Low interest rates allegedly foment excesses within the financial system that hikes can help to stave off. In cruder terms, advocates for these arguments see rate hikes as a form of ‘bubble control.’ This is a tempting view if you strongly believe that low interest rates are a critical factor in capital misallocation and 'malinvestment.' We do not subscribe to this view (bad investment decisions can materialize at both high and low risk-free interest rates).
No matter the Fed's intentions, higher interest rates will have more direct effects undermining financial stability than they will promoting price stability for the foreseeable future. Interest rate hikes, to the extent they bite, contribute to higher volatility, higher liquidity risk, lower valuations, higher credit risk, and higher equity cost of capital. All of these dynamics are the direct seeds for financial crisis; they can grow uncontrollably in the absence of appropriate policy interventions. And once these dynamics are set in motion, reversing interest rates is rarely sufficient to reverse these dynamics.
Although they would not describe it that way, the Fed's monetary policy stance today could be effectively summed up as “We want to make it more difficult for banks to raise capital” by continuing to tighten financial conditions. Bank capital (equity and highly stable liabilities) is both the short- and long-term bulwark against financial stability threats. In the current moment where bank share prices have broadly plummeted and distress is already evident, it is going to be difficult to reconcile a financial conditions tightening campaign with a commitment to financial stability.
