The collapse of Silicon Valley Bank has made the Federal Reserve’s life more complicated. It is trying to bring down inflation. Until the middle of last week, that meant raising interest rates enough to throttle down the economy. The economy has not been cooperating. In January, it added 500,000 new jobs and in February it added 311,000 new jobs. That is more than 800,000 jobs in two months, which adds a lot of demand to the economy at a time when the Fed is trying to tamp down demand.
Also, inflation is proving to be stubborn. The Fed has been raising interest rates steadily for a year now, and inflation is not coming down fast. In fact, there were signs in January that it was accelerating a little. So the Fed’s only lever is to keep raising interest rates. There was a time a couple months back when folks thought that it might slow down or just raise rates a little. But after the most recent jobs and inflation numbers, the thinking shifted to the possibility of a half-point rate hike at the March 21-22 meeting.
Then Silicon Valley Bank failed. When a regular company goes bankrupt, it doesn’t freak people out. When when a bank collapses, it does. Banks have our money, in savings and checking. Some of it is insured, but only a certain amount. So if you have a lot of money in your bank accounts, and you hear that a bank has failed, it makes you nervous. Is your bank safe? Should you take your money out and find somewhere else to put it? That is not good.
A big reason that the SVB failed was the past year of Fed interest rate hikes. Suddenly, a lot of the bonds that SVB held – where it had invested customers’ deposits – were worth a lot less. And it had another problem. A lot of its customers were tech companies. Tech companies, when they start out, raise money from investors to hire staff and pay for things, because their revenues aren’t big enough yet. When they can’t raise more money, they dip into their existing bank deposits. They burn cash. In the past couple of years, it has become difficult to raise money, so tech startups were burning a lot of cash. In order to meet customer withdrawals, SVB had to sell bonds, and when they did, they had to record big losses, in the billions of dollars. When this came out last week, customers started withdrawing more cash because they thought SVB was in trouble.
This all started because SVB wasn’t smart about where it was stashing its customers’ deposits, it took a big chance, and the Fed started raising interest rates relentlessly last March, and finally SVB’s investment model broke.
So now the Fed, in addition to trying to get inflation under control, has to worry about other banks that may be exposed to interest rate risk. The Fed does not want other banks to collapse, and it doesn’t know how many other banks are in precarious shape by taking in short-term deposits and investing in long-term bonds that can lose their value if interest rates keep climbing.
At this moment, speculation is bouncing all over the place about what the Fed will do next week. The CME Fedwatch says there’s an 80% chance it will go up a quarter point. Last week it was predicting a half-point.
Tomorrow morning, the February consumer price index will come out. It is expected to show around 6% year over year inflation and 5.5% core inflation, ex. food and energy. If it comes in hotter, that will give the Fed more reason to go a half point. If it comes in less, the Fed may have leeway to only go a quarter point. At this moment, the stock market seems to be pricing in a quarter point, but we will see what it does after the CPI report at 8:30 Tuesday morning. Sentiment could shift in a few minutes, depending on what the CPI data shows.
Basically, it is all about the Fed and how it might react to inflation and jobs data and to events like bank failures. The Fed is trying to get inflation back down to 2%, where it was two years ago before it heated up. The government has said it will backstop deposits, but the Fed is still wary of putting a lot of stress on the banking system, so it has to worry about more than just inflation. One thing looks almost certain, which is a recession in the next year or so. The yield curve, which is pretty reliable as an indicator, is as inverted as it has been in 40 years, and that generally predicts a recession. Of course, this economy has shown a lot of resilience, so nothing would surprise me.