The Painful Task of Resetting the U.S. Economy

In the past two weeks, serious difficulties at a small number of banks have emerged. Isolated banking problems, if left unaddressed, can undermine confidence in healthy banks and threaten the ability of the banking system as a whole. That is why, in response to these events, the Federal Reserve, working with the Treasury Department and the FDIC, took decisive actions to protect the U.S. economy and to strengthen public confidence in our banking system. These actions demonstrate that all depositors’ savings in the banking system are safe.

So, as we've all seen over the past few weeks, banks have been under the pump in the U.S. We've seen nasty bankruptcies at Silvergate, Signature Bank, and of course the big one, Silicon Valley Bank, which saw depositors attempt to withdraw $42 billion in just one day. This triggered the Federal Reserve, alongside the FDIC and the U.S. Treasury, to step in and provide immediate assistance. It was announced that in the case of Signature and SVB, in fact, all depositors would be made whole, which is a big move considering the FDIC usually only insures the deposit's first $250,000. Ninety-five percent of SVB's deposits were uninsured.

Now we finally get some answers. Just a few days ago, Jerome Powell gave a 45-minute press conference where he explained how the Federal Reserve seized the banking crisis and what they're going to do about it. Let's start with the big-ticket item: Silicon Valley Bank.

On a basic level, Silicon Valley Bank management failed badly. They grew the bank very quickly and exposed the bank to significant liquidity risk and interest rate risk without hedging that risk. We know that SVB experienced an unprecedentedly rapid and massive bank run, a very large group of connected depositors, concentrated in a very, very fast run— faster than historical records.

As Jerome explained, there were a few key aspects that led to SVB's demise. Firstly, they had all their eggs in one basket. A few years ago, they bought a tremendous amount of long-term U.S. Treasury bonds. The problem with that is, as interest rates go up, the value of the bonds goes down. Now, there's no stress if you can just hold those bonds through to maturity; that's totally fine. But SVB suffered a lot of withdrawals from depositors, which forced them to sell these bonds prematurely just to cover those withdrawals.

The problem is that made them realize substantial losses, which prompted them to try and raise capital, which spooked investors and then triggered a big bank run. So, as Jerome said, the main problem here was that SVB management left the bank open to massive interest rate risk and they didn't hedge that. Plus, to make matters worse, they also had a concentrated group of depositors. They had tech businesses, they had startups, and that really triggered the problem in the first place.

In this interest rate environment, these businesses all turned to their deposits in Silicon Valley Bank to meet their own liquidity needs. So the bank went down, but as we now know, depositors didn't, and it's all thanks to the Fed, you along with the FDIC and the Treasury. The Fed board decided to invoke the systemic risk exception to allow uninsured depositors to be protected at these two banks.

I was just wondering if you could speak to why that decision was made. Was it purely a confidence issue, or was there a concern that there would be some sort of economic contagion or financial contagion from the failure of these banks?

The issue was really not about those specific banks, but about the risk of contagion to other banks and to the financial markets more broadly. That was the issue. In the case of Silicon Valley Bank and Signature Bank, the FDIC swooped in and closed them down. But as we know, the FDIC deposit insurance is only on the first $250,000.

In the case of SVB, because all their clients are businesses that usually have a lot more than $250,000 in the bank, it turned out that 95% of their deposits were unprotected under this insurance scheme. This triggered the Fed, in conjunction with the U.S. Treasury and the FDIC, to announce that, in fact, in the case of SVB and Signature Bank, all depositors would be made whole.

Now we know from the Fed's perspective there was genuine concern that these bank collapses would have a serious flow-on effect to the whole economy. This is what they refer to when they talk about contagion. Essentially, if SVB goes under, then their depositors, those startups and other tech businesses, all go down too.

Because the economy is very, very interconnected under the principle that one person's spending is another person's income, this can very quickly cause widespread problems if left unaddressed. So the Fed obviously wants to limit the ripple effects from these two banks going down.

I will say one resource that has really helped me understand this whole situation, as well as the ongoing updates, is Morning Brew, who are the sponsor of today's video. For those that don't know, Morning Brew has a free daily newsletter that sums up all of the important news across tech, business, and finance. It's actually a very enjoyable five-minute read, and it gets sent straight to your inbox every day, so it's incredibly helpful in staying updated with what's going on in the business world.

For example, all of that information I just spoke about regarding the $250,000 worth FDIC insurance and the problems that poses with a bank like SVB? Yep, I got it from reading Morning Brew. It’s also very handy when you have an unfolding saga like this because you get the latest updates every single day. So I really like it, and of course, the newsletter is completely free. So definitely sign up using my referral link in the description and just give Morning Brew a try for yourself; let it make your life easier, and plus, it really helps support the channel as well.

Lastly, I will just say thank you very much to Morning Brew for their ongoing support of our community here on YouTube. But back to it, so the Fed wants to limit the ripple effects right now. However, one question that a lot of people are asking is, well, if this happened to SVB, is it likely going to happen to other banks as well?

These are not weaknesses that are at all broadly through the banking system. This was a bank that was an outlier in terms of both its percentage of uninsured deposits and in terms of its holdings of duration risk. This is actually shown by Michael Murray on Twitter recently when he posted this image. As you can see, Silicon Valley Bank is way up in the top right, away from everyone else, meaning that they had huge unrealized losses versus their cash on hand. At the same time, they had a very high percentage of their deposits uninsured. They were essentially the prime candidate to go bust from a bank run.

As you can see, no other bank quite has the same profile. But while it is an outlier, obviously, you know, this mess still happened. Jerome was also asked what the Fed is now going to do about it.

For our part, we're doing a review of supervision and regulation. My only interest is that we identify what went wrong here. How did this happen is the question. Then make an assessment of what are the right policies to put in place so that it doesn't happen again and then implement those policies. The review is going to be thorough and transparent. It is clear to your last question that we do need to strengthen supervision and regulation. I assume there will be recommendations coming out of the report and I plan on supporting them and supporting their implementation.

For all the stick that Jerome Powell has copped over the last few years, you know, honestly, sometimes for me as well, I actually really like his commitment here. He seems genuinely set on analyzing what went wrong and fixing the relevant policies to ensure that a situation like this doesn't happen again. And that's all you can ask for really. You know, bad things happen, mistakes are made, but it's always what happens next that counts.

Now lastly, before we move on, Jerome also briefly commented on the Credit Suisse saga. He didn't have much to say because it's not really in his jurisdiction, but I'll play you the clip here anyway if you wanted to have a listen.

So I was wondering if you could go to the Credit Suisse merger. I mean, wasn't that the big gorilla in the room? Didn't you breathe a sigh of relief when that merger happened?

Thanks, sure. So, you know, that was really the Swiss government, but we, of course, were following it over the course of the weekend and we were engaged with their authorities in the way that you would expect, all the ways that you would expect. It seems to have been a positive outcome in the sense that the transaction was agreed to and it has been, and the markets have accepted it, and it seems to have gone well. I think there was a concern that it might not go well. So coming into the middle of this week, yes, I would say that that has gone well so far.

Credit Suisse, of course, is the big Swiss bank that failed last week and was essentially acquired by UBS for pennies on the dollar with the help of the Swiss version of the Federal Reserve, which is called the Swiss National Bank. But with Credit Suisse, this wasn't the same situation as what happened to the U.S. banks. As I said, it's well outside Jerome Powell's jurisdiction, so it doesn't surprise me that he didn't really have much to say other than it seems like what happened was probably the best possible outcome.

So overall, that was what Jerome had to say about the banking issues. But of course, that wasn't even the main topic of this press conference. This press conference was primarily to discuss the Fed's next move when it comes to interest rates. If you haven't already heard, with inflation at 6% and the Fed funds rate at 4.5% to 4.75%, leading in, this is what the Fed decided to do at today's meeting: the committee raised the target range for the federal funds rate by a quarter percentage point, bringing the target range to 4.75% to 5%.

We remain strongly committed to bringing inflation back down to our 2% goal. Price stability is the responsibility of the Federal Reserve. Without price stability, the economy does not work for anyone. So, 0.25 rate hike, with the Fed acknowledging they will continue on their path of getting inflation back down to 2%.

But one point that I found really interesting in this press conference is that Jerome actually said that going forward, the Fed may not need to raise rates over the next little while in order to control inflation. The reason has to do with the bank crisis we've been seeing over the past few weeks.

Listen to this:

"We believe, however, that events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes. It is too soon to determine the extent of these effects and therefore too soon to tell how monetary policy should respond. As a result, we no longer state that we anticipate that ongoing rate increases will be appropriate to control inflation. Instead, we now anticipate that some additional policy firming may be appropriate."

Jerome is saying that because banks are a bit hesitant right now, this will naturally cause a tightening of credit, which will put further pressure on businesses and citizens, which will likely lower inflation without any rate hikes. This is a really interesting point, and Hamish explained it very well to me on the latest episode of the Young Investors Podcast, just to kind of break down that take out of financial jargon for those who are interested.

Tighter credit conditions, essentially what they're referring to is essentially banks with this crisis and a lot more withdrawals happening from even safe banks. People are just panicking a little bit more with this crisis; banks are loaning out less money at the moment, so they're providing less credit to other businesses and individuals just to protect themselves during this.

So those tighter conditions essentially slow the rate at which money moves around the economy, and that has kind of a ripple effect that goes across the economy. As he’s saying, we probably haven't seen that play out yet. So he's just kind of pausing long enough—apparently not. Yeah, unfortunately, in finance, these things take time to kind of ripple out.

So yeah, he’s just being a little bit more cautious not to add to issues that may be there but we can't see them yet. Long story short, concerns in the banking sector mean banks hand out less money, which can slow the economy and thus inflation without the Federal Reserve actually having to do anything.

"Remember, for purposes of our monetary policy tool, we're looking at what's happening among the banks and asking: Is there going to be some tightening of credit conditions? Then we're thinking about that as effectively doing the same thing that rate hikes do, so in a way that substitutes for rate hikes. The key is we have to have policies that are tight enough to bring inflation down to 2% over time. It doesn't all have to come from rate hikes; it can come from tighter credit conditions."

So that's what we're looking at, and it's highly uncertain how long the situation will be sustained or how significant any of those effects would be, so we're just going to have to watch.

As Jerome says, it's early days and we'll have to wait to see what happens next. With that in mind, what does he think about the future? What will the Fed's plan be moving forward?

"I mean, you know, in a way, the early data in the first part, the first five weeks of the intermediate period pointed to stronger inflation and a stronger labor market, so that pointed to higher rates. Then, this latter part, the possibility of credit conditions tightening really offset that effectively. So going forward, as I mentioned, in assessing the need for further hikes, we will be focused, as always, on the incoming data and the evolving outlook, and in particular, on our assessment of the actual and expected effects of credit tightening."

Essentially, Jerome expects credit tightening to bring down inflation, which may result in the Fed just sitting back and watching it fall. But he also reassures that if credit tightening is quite minor and inflation keeps roaring, then for sure the Fed will step in and continue rate hikes until inflation is controlled and brought down to around 2%.

So anyway, guys, that is it. Hope you enjoyed the video. Please leave a like and subscribe to the channel if you want to see more. But apart from that, I'll see you guys in the next video.