The key question in the short run is how much this effort to avert a banking crisis is going to undercut the effort to bring down inflation.
For central banks throughout history, there has been a recurrent tension between price stability and financial stability. Raising short-term interest rates acts as a brake on economic activity by increasing the cost of credit throughout the financial system.
First, let’s briefly recap what happened last week. Last Sunday night, regulators released their three-part plan to avert a banking crisis. The measures were extraordinary. First, with the help of the Treasury Department and the Federal Reserve, the Federal Deposit Insurance Corporation invoked the “systemic risk exception” to protect uninsured deposits at SVB and Signature.
Is there a parallel for the authorities’ intervention? Several commentators cast their minds back to the rescue of Continental Illinois in 1984, the largest bank failure in US history until the 2008/2009 financial crisis. Paul Volcker, then Fed chairman, was persuaded to protect the bank’s uninsured deposits for the sake of financial stability.
Between March and August the funds rate increased from an average 9.9 to an 11.6 per cent rate. The operating target for adjustment plus seasonal borrowing remained at $US1 billion during this period, but in order to avoid the appearance of internal problems, fewer banks were borrowing. Growth of the monetary base and money slowed. The unemployment rate remained above 7 per cent; the market could see that policy had tightened.
Bending the rules of that time, the FDIC ruled that Commonwealth was “essential” because of its “service to the black community in Detroit, its contribution to commercial bank competition in Detroit and the upper Great Lakes region, and the effect its closing might have had on public confidence in the nation’s banking system”.
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