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For markets, the demise of Silicon Valley Bank signals a painful new phase

to Suppressing inflationThe saying goes, central bankers must tighten monetary policy until something breaks. For most of the past year, it’s been easy to dismiss these clichés. Starting in March 2022, the US Federal Reserve raised interest rates at the fastest rate since the 1980s. Even as markets fell, the global financial system remained clear of rubble. When Britain’s pension funds wobbled in September, the Bank of England quickly helped correct them. The most notable breakdown – breakdown FTXa disgraced former cryptocurrency exchange — was out of the mainstream, and regulators say it was caused by fraud rather than the Fed.

Now something broke. Silicon Valley bank failure (svb), a mid-tier US lender that filed for bankruptcy on March 10, has sent shock waves through financial markets. Most noticeably, however, are the convulsions in stocks of other banks, which investors fear may have similar vulnerabilities. NasdaqThe stock index of banking stocks fell by a quarter in the space of a week, erasing all its gains over the previous 25 years. Shares in regional lenders have been hit harder. With the publication of this article, the recovery has begun. However, financial markets have entered a new phase: the Fed’s tightening cycle is beginning to unfold.

One of the advantages of this stage is that the markets are suddenly working with the Federal Reserve instead of against it. For more than a year, central bank officials have been repeating the same message: that inflation is proving more stubborn than expected, which means that interest rates will need to rise higher than previously expected. This message was reinforced by data released on March 14 which showed that core consumer prices rose again faster than expected.

Policy makers want to tighten financial conditions – such as lending standards, interest costs or money market liquidity – which will reduce aggregate demand and thus limit price rises. Since October, the markets have been going the other way. A measure of financial conditions compiled by Bloomberg, the data provider, showed it steadily loosening. Over the past week, all of that decline has been reversed, even taking into account the rebound in bank stocks. svbThe Fed’s collapse shocked the markets into doing the Fed’s job.

This does not mean that investors have given up on fighting the Fed. They are still betting that it will soon start lowering interest rates, although officials have given no such indication. But the battlefield has moved on. Earlier this year, expectations of a rate cut stemmed from hopes that inflation would fall faster than the Fed expected. Now they reflect fear. On March 13, the two-year Treasury yield fell by 0.61 percentage points, the largest single-day drop in more than 40 years. Given the failure of some banks, investors are betting that the Fed will cut interest rates not to tame the inflation monster, but to avoid breaking anything else.

Combined with the reaction in other markets, this indicates a degree of cognitive dissonance. After the initial decline, the broader stock indices have recovered strongly. the s&s The index of 500 large American companies is equal to its position at the beginning of the year. The dollar weakened slightly, which tends to strengthen in crises as investors flock to safety. On the one hand, investors believe that the Fed should fear the failure of other institutions enough to start cutting interest rates. On the other hand, they do not fear the repercussions of such a failure enough to reflect it in asset prices.

The reason for this discrepancy is the supposed tension between the Fed’s inflation target and its duty to protect financial stability. to fail svb, which was rooted in losses from fixed-rate bonds (which fell in value as interest rates rose), seems to be evidence of this. Since even fighting inflation pales in importance next to stabilizing the banking system, the argument goes, the Fed cannot raise interest rates any further. This reduces recession risks, gives a boost to stocks and reduces the need for safe haven assets like the dollar.

Don’t be sure. the next svbAfter its collapse, the Fed promised to back up other banks. Supporting it – lending against securities worth no more than two-thirds of the loan’s value – should prevent any remote-paying institution from collapsing where interest rates end. Alongside this generosity lies an uncomfortable truth. To get inflation out of the economy, the Fed needs to make lenders nervous, loans expensive, and companies risk-averse. Let the reckless banks like svb Failure is not a tragic accident. It’s part of the Fed’s job.


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