The Fed is playing with fire: SVB proves it 

Federal Reserve Chairman Jerome Powell and the Fed board he dominates would like to raise interest rates further, but the failure of the Silicon Valley Bank (SVC) gives them pause. They know that higher rates would add to the damage they have done already with seven rapid fire rate increases in 2022.  

Why is the Fed so intent on hiking rates when report after report shows that inflation is coming down? The answer is that the Fed’s monetarists believe that slowing the economy is the way to fight even this COVID-related inflation, and that the Fed’s original role as supervisor of the private financial system is essentially unneeded — until as the SVB case shows, the Fed’s laissez faire view of regulation lets a crisis develop. 

The SVB fiasco underscores once again the need to supervise private finance. The Fed instead has become the proverbial one trick pony. Its anti-inflation preoccupation and tool is across-the board monetary tightening to slow the economy. It does not try to work on the specific economic sectors that are actually driving today’s inflation or pay adequate attention to the Fed’s important regulatory responsibilities. 

Inflation now is coming down and the Fed needs to get its foot off the brake. Inventories have been rebuilt at retailers, and this is putting downward pressure on a wide array of prices. Transportation bottlenecks have been cleared so these costs are stabilizing. Other reports suggest that housing prices and rents are likely to soften over the next several months. There is a glut of office space, so lease rates are easing. Food prices are likely to stabilize or soften too. 

An important question then is why inflation has not dropped faster and further. The answer is not that the economy is growing too fast as Fed policy implies. It is that there are war-related problems in the vital energy area. Energy has been a major part of the inflation story from its beginning 18 months ago and is likely to continue to be so. The Fed does not seem to understand this. 

Everyone knows that gasoline prices are down from their $5 gallon peak. Other energy prices, however, are still a major source of inflationary pressure. This is true for natural gas for home heating and electric generation and for diesel that powers trucks and machinery. Heating oil, propane, LNG and fertilizer are also up sharply for war-related reasons.  

Inflation in the energy area hits consumers directly in their heating and electric bills. Less well understood and measured, energy inflation keeps upward pressure on the cost of manufactured goods, farm products, commercial transportation, and private and public services. Nevertheless, overall inflation continues to ease with analysts saying it could fall to 3 or 4 percent by the end of 2023.  That is better than even the most benign Fed-engineered recession. 

The Fed, however, has a bee in its bonnet. Two percent inflation has become a magic number as was unemployment below 6 percent for deficit hawks in the 1980s and ’90s. Most believed then per a model called the Phillips Curve, that unemployment below 6 percent would lead to surging inflation. That magic number turned out to be ridiculously wrong. 

To get to its 2 percent Nirvana fast, however, the Fed has more than doubled mortgage interest rates since December 2021. Its policies also push up rates on credit cards, auto and other consumer loans. Increases in borrowing costs like these are always harder on credit-dependent working people and small businesses than on the well-heeled and larger businesses. Those with deep pockets have money to fall back on that less affluent consumers and businesses do not. When prices fall the well-off lick their chops and buy up credit-dependent small firms and other assets on the cheap. This may be happening with the assets that SVB is being forced to sell now. 

Powell and the inflation hawks not only downplay the fact that inflation is coming down. They ignore the history of recessions that follow the kind of deflationary policies they are pursuing. Periods of falling prices and wages have been many, many times more common, painful, and prolonged in American history than periods of inflation. Periods of inflation in the U.S., in fact, have almost always been times of war. 

The Great Depression of 1929 to 1940 and World War II that followed (1941-45) are prime examples. Franklin Roosevelt took office in March 1933. Prices and wages had already fallen by roughly 30 percent since the Crash in 1929. The new president shared with the reactionary elites of his day the conviction that government spending crowds out private investment and is inflationary. Nevertheless, his first New Deal administration from 1933 to 1937 spent large amounts of money on new and still-celebrated employment and public works programs like the Civilian Conservation Corps and the Works Progress Administration. It also launched sweeping reforms of the U.S. financial and related regulatory systems. These New Deal spending programs and actions by 1937 had brought unemployment down to less than 15 percent from 25 percent in 1932.  

Then the old tight money orthodoxy so grotesquely familiar today made a comeback. The Congress cut New Deal spending sharply after 1937, pushing unemployment up to almost 20 percent again. Employment did not recover until wartime spending saved the Free World, wiped out unemployment, and powered a post-war decade of prosperity.  

The government found ways to finance World War II because in wartime what passes for financial wisdom in peacetime is mothballed.  Roosevelt’s Treasury secretary, Henry Morgenthau, put his tight money convictions aside and ordered the Federal Reserve to buy all the bonds the Treasury issued at 2 percent or less, and the Fed complied. When the war was over Morgenthau bragged that he had financed the government’s $200 billion spending for the war at 1.94 percent. 

Americans should be very scared by the Fed’s continuing preference for deflation given SVB’s collapse, and the long history of U.S. recessions related to tight money. Unemployment and commercial failures for the past 200 years have followed steps that have raised interest rates, limited credit-based purchases, and cut government spending.  

Albert Einstein said that the definition of insanity is “doing the same thing over and over and expecting different results.” Americans should be asking whether the Fed’s deflationary policies and disinterest in regulating the financial system fit this definition of insanity, and whether they will lead again to an unnecessary and politically dangerous recession.  

Paul A. London, Ph.D., was a senior policy adviser and deputy undersecretary of Commerce for Economics and Statistics in the 1990s, a deputy assistant administrator at the Federal Energy Administration and Energy Department, and a visiting fellow at the American Enterprise Institute. A legislative assistant to Sen. Walter Mondale (D-Minn.) in the 1970s, he was a foreign service officer in Paris and Vietnam and is the author of two books, including “The Competition Solution: The Bipartisan Secret Behind American Prosperity” (2005).