Fed’s Attempt To Stabilize Banks And Fight Inflation At The Same Time Is Tricky

When it comes to price stability and financial stability, how will the Federal Reserve strike a balance? In the lead-up to next week's Federal Open Market Committee rate-setting meeting, that is the question troubling the market.

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Last week's sudden collapse of Silicon Valley Bank triggered a banking crisis, in which the Federal Reserve focused on fighting inflation. There was a sense of distance between the recession and the financial crisis.

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Those days are over. Multiple banks were closed, uninsured deposits were covered, and an emergency liquidity facility was launched by the Fed. A potential dilemma was revealed with those actions: policy could be too tight for the financial system but not tight enough for the economy as a whole.

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It is an awkward situation in which monetary policy is being pulled in two different directions. As policy tightens further, inflation will be brought down to acceptable levels, but the banking system could be further destabilized. There is tension between the two goals.

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What will the Fed do since it is responsible for both? As far as inflation is concerned, there is no playbook that it will follow, but it will do as much as it can and as early as possible on the banking system to give it some breathing room.

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First and foremost, the Fed will reinforce the banking system -- which has already begun. As a result of joint actions by regulators, risk will be ringfenced to prevent it from spreading. By doing so, we hope to make the financial system robust enough to withstand even tighter policy.

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Continuing along the same line, the Fed could use more of its arsenal if last weekend's intervention didn't suffice. Capital and liquidity requirements can be strengthened through the use of its balance sheet. Regulatory agencies and Congress may even be able to help.

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As a consequence, the trade-off becomes more treacherous if those measures fail to stem the spread of contagion in the banking system. Inflation in core consumer prices increased 0.5% in February, according to data released Tuesday. It is unlikely that the Fed will be able to take a break from its fight against inflation while inflation remains high.

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Financial stability can come back to haunt policymakers who ease policy temporarily for the sake of financial stability. That psychology could take hold again if inflation expectations spike again. The path to worse financial stability might only be paved by tolerating higher inflation. There is no solution to a financial crisis if we allow it to spiral out of control.

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In light of the last two episodes, which both featured recessions and easing cycles, Fed officials are willing to adapt their crisis playbook.

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Because of inflation risk, the Fed is now unwilling to lower the policy rate below zero, as it was unable to do in 2008. Likewise, when events flare up, the Federal Reserve implements surgical fixes when easing policy across the board is not possible.

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As a result of the recent interventions, the financial system will have time to adjust, rather than being overwhelmed by the sudden shock. To avoid potholes causing a catastrophe, the Fed hopes minor bumps in the road do not turn into potholes.

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Unless this is accomplished, the Fed may face much greater challenges: relentless inflation, sputtering economic growth, and a financial system dripping in trust. This is something we all hope will not happen.