Fed Raises Interest Rates Despite Bank Failures

The Federal Reserve Board voted unanimously on Wednesday to raise interest rates for the 10th straight time to the highest rate since 2006, before the Great Recession. Days before the Fed’s meeting, a third (since March) large bank failure shook markets and investor confidence, making the Fed’s quest to “return inflation to its 2 percent objective” an increasingly delicate operation.

In response to historic inflation, which reached an annual rate of 9.1% in June 2022, the Federal Reserve began to raise interest rates in March 2022. In 10 successive increases, the Fed has ratcheted the target federal funds interest rate from a range 0.0%-0.25% to a range of 5%-5.25%. While the federal funds rate is only used for bank-to-bank transactions, other interest rates are pegged to it; when the federal funds rate increases, other interest rates increase in proportion.

This rapid increase in interest rates spelled trouble for certain banks who had invested heavily in government bonds at the previously low interest rates, because it severely discounted those bonds. By early 2023, the successive interest rate hikes had pressed some banks to the breaking point, particularly when combined with poor management and a lack of depositor confidence. On March 10, the Federal Deposit Insurance Corporation (FDIC) took over Silicon Valley Bank, followed by Signature Bank on March 12, and First Republic Bank on May 1. The three bank failures were the third, fourth, and second largest in U.S. history, with the three banks combining for $548.5 billion in assets and $367.9 billion in deposits.

And the banking trouble may not be over yet. After the Fed’s announcement on Wednesday, PacWest Bancorp shares lost 60% of their value, while stocks for Western Alliance, Comerica, and Zions also dropped 15-35%.

In their March 22 announcement, the Fed “anticipate[d] that some additional policy firming may be appropriate.” Perhaps due to the heightened potential for continuing banking turmoil, that language was removed in the May 3 announcement from a paragraph that is otherwise quite similar. At a press conference following the announcement, Fed Chairman Jerome Powell said, “We are prepared to do more” to counteract inflation, but that they will make decisions on a “meeting-by-meeting” basis.

The Consumer Price Index (CPI) for all items, a main measure of inflation, had increased by 5.0% in March 2023 over a year earlier (April’s numbers will be released on May 10). While this is down from the soaring 9.1% annual inflation experienced last summer, it remains significantly far above the Fed’s target of 2% annual inflation. In fact, the CPI measure for “all items less [that is, minus] food and energy,” considered to be a less volatile measurement, actually increased in March to an annual rate of 5.6%. Heightened interest rates may have weakened inflation, but the Fed still has more work to do.

Yet, as the recent bank failures have shown, there are real-world economic consequences — painful ones — associated with rising interest rates. One consequence that hits literally close to home for many Americans is the impact of rising mortgage rates — now at 6.4%. As a result, monthly mortgage payments on a typical home at current interest rates are 50% higher now than they would have been on January 31, 2022. Would-be homebuyers (especially first-time homebuyers) must either content themselves with a much smaller house or wait to purchase a home until they can afford it — perhaps years or even decades. Such consequences make the Federal Reserve’s task a delicate one, which is why it has inched up interest rates by degrees, and not all at once.

Then again, all of the Fed’s painstaking maneuvering to raise interest rates without tanking the economy may evaporate in an instant if the U.S. federal government fails to make payments on its debt. “No one should assume that the Fed can protect the economy from the potential short and long-term effects of a failure to pay our bills on time,” warned Powell. Treasury Secretary Janet Yellen said that the U.S. could be in default as soon as June 1 if no deal is reached to raise the debt limit.

Speaking of payments on government debt, that too will become costlier due to rising interest rates.

There’s a moral to this story. It’s important to remember that bank failures, rising interest rates, and inflation are not inexplicable phenomena that come and go without explanation. They are the natural, expected consequences of government policies. Free pandemic spending combined with enforced stay-at-home idleness created a situation where too many dollars were chasing too few goods — a textbook recipe for inflation. The only known policy level to control inflation is raising the interest rate. But, like chemotherapy, raising the interest rate is a cure with serious side effects, which we are only beginning to experience.

The point is, sometimes (as now) it’s easier to avoid making serious mistakes in the first place than to scrub clean the fallout afterwards. Proverbs 17:14 applies this principle to interpersonal quarrels, “The beginning of strife is like letting out water, so quit before the quarrel breaks out.” Letting out water only makes the hole larger and more difficult to repair. This principle for maintaining relationships also applies to government policies to maintaining conditions of economic prosperity. But we will only benefit from this knowledge if we learn the hard lessons of the past and avoid foolish choices to satisfy our momentary whims.