Clipped from: https://www.thehindubusinessline.com/opinion/why-the-fed-is-right-in-hiking-rates/article66774792.ece
Its job is to control inflation in an overheated economy. Financial stability is best addressed through specific regulation, and not by pausing rates
Over the last couple of years, there have been intense debates on monetary policy — its objective, mode, timing and efficacy. The recent collapse of Silicon Valley Bank and Signature Bank magnified this and brought into question what the US Federal Reserve should do next in terms of its interest rate. Many called for a pause in in interest rate hikes, the argument being that doing otherwise would destabilise the financial sector, particularly banks. The Fed, however, announced a quarter point hike in interest rate. And it did the right thing.
Not doing so would have been problematic. To understand why, we need to look at some of Fed’ past actions, and indeed mistakes. The Fed started increasing interest rates only about a year back — from March 17, 2022, to be precise. The Fed had kept interest rate at zero from 2008 onwards for an unprecedented number of years, till 2016. Gradually it increased the interest rate to 2.5 per cent by 2019, only to bring it back sharply to zero in 2020 with the onset of Covid.
Zero interest rate
The objective in doing so was to stimulate the economy and support growth. This led many to believe that it was normal to have zero interest rate in the economy. This belief was widespread not only among those who ran banks and other businesses, but also among policymakers.
The Fed, on its part, did nothing. Even discussions around inflation, which is the Fed’s primary responsibility, evaporated. Even when inflation started increasing, it was downplayed as transitory. This was a costly mistake. It brought into question the Fed’s ability to fight inflation. It had to rectify that notion and the only way to do that was to own up the mistake (see for example, https://www.nytimes.com/2023/01/10/ magazine/inflation-federal-reserve.html) and aggressively increase interest rates. Given this history, now the Fed is not in any position to pause the rate hike, or even appear to do that, given that inflation rate continues to be high at around 6 per cent.
Also, it is wrong to expect that the mismanagement in banks will be sorted out if interest rates are not raised further. This view conflates two different functions of the Fed — controlling inflation and financial stability. A root cause of the crisis in US banks is this inability to take into account the possibility of increasing interest rates. This has led to banks ignoring interest rate risk completely, a fatal mistake.
A simple understanding of macroeconomics and historical events would have cautioned the managers and prevented such disastrous decision-making. Not increasing interest at this point will hardly undo that. It is doubtful that the banks will get even a temporary reprieve if interest rates stayed at the previous rate, which is already high.
The other aspect is that in contrast to the Fed’s independence to set interest rates to fight inflation, regulating financial stability is a more complex matter and is subject to several laws, besides political will. For instance, what if the Dodd-Frank Act was not watered down during the Trump regime? Could it have prevented the current crisis in banks in the US? The fact is that regulation is a function of many extraneous factors.
Moreover, the issue of optimal regulation is a difficult one. Over-regulation can thwart innovation, investment and growth, but lack of regulation can lead to chaos. The challenge is to find the sweet spot. Further, regulation itself has to be dynamic, and change depending on conditions. A lot more research and understanding on how to design that is needed. But one thing is clear: reducing interest rate cannot compensate for poor regulation.
The call for a pause in interest rate hike was misguided in another respect. The Fed has on multiple occasions said that it thinks the economy is overheated and wants to guide it to a landing. The question is whether it will be a soft or a hard landing. On this, the Fed also made it clear that it expects unemployment to increase.
Thus, there is a clear loss to labour income. The SVB and Signature Bank, episodes helps the economy find that landing, except that in this case the loss accrues to those who hold capital. How could the Fed have justified trying to shield capital while explicitly expecting unemployment to rise?
Considering all things, the right thing for the Fed to do in conducting monetary policy was to keep its focus on inflation, and it did just that. The fact that it needs to take a hard look at its regulatory function and make amends there is equally true, but interest rates are not the right instrument for that.
The writer is Professor, Department of Economics, Shiv Nadar Institute of Eminence