Defeating Inflation Doesn't Mean Losing The War Against Banks

The fear in the banking sector is persistent.

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Late last week, attention turned to Germany's venerable Deutsche Bank, whose stock price fell about 15% on Friday and prompted German Chancellor Olaf Scholz to make a rare public show of support. A rise in credit default swaps offered by Deutsche Bank (ticker: DB), which act as a sort of insurance against the collapse of the German banking behemoth, was equally unsettling.

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The Federal Reserve announced that member banks used its discount window the most frequently ever on a weekly basis, exceeding even the height of the global financial crisis in 2008. That is clear evidence that American depositors, especially those at small and medium-sized banks, are still anxious about the security of their funds. Adding to those worries was Treasury Secretary Janet Yellen's revelation during testimony before Congress that the U.S. To provide universal insurance for all depositors, Treasury, the Federal Deposit Insurance Corporation, and the Federal Reserve have not yet been prepared. Since that such action would need congressional approval, that seems sensible. But, it was nonetheless a warning to the markets. 

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In the meantime, the Federal Reserve raised interest rates last week by a quarter-point, following a half-point rate hike from the European Central Bank 10 days earlier. Most observers believed the growth to be less than it would have been had banking problems not emerged. However, some analysts are unsure if the Fed can fulfill its responsibilities for financial stability and inflation gave that U.S. core inflation gauges are more than double the Fed's target level.

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In fact, there is a degree of intrigue on schadenfreude—about if the Fed is losing its grip on the money supply and hyperinflation in its attempts to tackle the financial crisis in some areas (particularly among supporters of cryptocurrencies).

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That's improbable. The Fed may metaphorically stroll while chewing gum at the exact same time. It can assist flimsy banks without giving up their inflation target.

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To understand why, consider the Fed's balance sheet as a reflection of money demand rather than as something the Federal Open Market Committee independently determines during times of financial hardship. The increase in Fed assets during the past several weeks (the Fed's balance sheet has increased from $8.3 trillion to $8.7 trillion since mid-March) is due to the Fed's efforts to meet the rising demand for money from anxious depositors, not a resumption to quantitative easing intended to boost the economy.

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Recalling the money quantity theory, which states that nominal GDP is equal to the stock of money ("M") times its velocity of circulation, is a more pedantic approach to think about this. Money velocity declines when depositors take money out of their bank and keep it (figuratively under the mattress). To maintain a steady nominal GDP, it is appropriate for policy to grow M proportionately. In this way, the Fed's role as lender of last resort is expanding its balance sheet to meet the increased demand for money. As a result, it is in line with, not in opposition to, its inflation target.

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The aforementioned is true in theory, however, it might not accurately capture the current situation. Many depositors might not be accumulating wealth, but rather redistributing it to the supposedly safer larger banks or into money market accounts with greater yields. Could such elements alter our analysis?

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Certainly, to a certain extent, but they do not alter the main finding, which is that the Fed will not soon relinquish the fight against inflation in order to triumph in the war against banking crises.

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To understand why, it helps to think about a straightforward framework I call the "story of two banks."

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Assume that there are just two banks in the United States: a big, stable bank called "Big Bank," which is supported by an example of all deposits as a "systemically important bank," and a small, unstable bank called "Dodgy Bank," which is losing deposits.

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Now imagine that Dodgy Bank encounters frequent withdrawals, with half of them traveling to Big Bank and the other half ending up in cash under the mattress.

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The Fed makes a loan to Dodgy Bank through the discount window to keep it from going down. Dodgy Bank will then have sufficient reserves to meet creditor needs.

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Half of the loans made through the Fed's discount window are compensating for the demand for cash as a result of the reserves utilized to cover cash withdrawals from Dodgy Bank. Nominal GDP is stable because the money supply has increased proportionally to the decline in money velocity.

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The reallocation of deposits from Dodgy Bank to Big Bank is supported by the other half of the Fed reserve injection into Dodgy Bank, however. Furthermore, since it has all the money it requires from the Fed to cover withdrawals, Dodgy Bank does not need to stop lending or even recall loans.

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Huge Bank, however, presently has expanding reserves and rising deposits. New loans may be made, or the money may be parked in securities, including U.S. mortgage-backed securities or Treasury bills.

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As a result, the Fed's injection of reserves could result in greater lending and spending in the economy as well as additional liquidity flowing into asset values unless steps are made to curb the risky lending or investment activities of Dodgy Bank. So, it is possible that the Fed's increase of its balance sheet (by its lending through the discount window) may turn out to be inflationary.

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Since this paradigm takes into account the substitution of deposit accounts between healthy and failing banks, it provides a better understanding of possible outcomes than the theory of money approach.

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But to get back to the original premise, this need not lead to a rise in inflation, nor does it imply that the Fed must pick between stabilizing banks or reducing inflation as the lesser of two evils.

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This is because there are solid grounds for anticipating that Dodgy Bank will actually be obliged to reduce its balance sheet as a result of depositor withdrawals. In the end, the Fed's role as lender of last resort is intended to be an emergency remedy rather than a long-term replacement for erratic deposits.

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Banks that fund themselves through the discount window, like Dodgy Bank, may be compelled to reduce their lending and investing activities, and they may finally be shut down. In that regard, it is likely that the alleged "excess reserves" generated across the banking industry by the Fed's operations will be less than initially appears.

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Of course, the Fed has the power to take away as well as give. The Fed can counteract the effect by engaging in "open market operations," which entails selling bonds to Big Banks and removing reserves from the system if the substitution of deposits results in excessive deposits, lending, and purchases of securities in the banking system.

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Money market funds do not have the same transactional capabilities as cash or bank deposits. In other words, when determining whether an excess of money may be causing inflation, the central bank just needs to monitor reserve requirements, not the level of money market funds.

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An overall banking crisis is a serious business. You must treat it seriously. If banks are failing, neither the market nor the Fed can function.

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A banking crisis, however, does not entail that the Fed must compromise on its goals. The Federal Reserve can more than walk and chew bubblegum at the same time thanks to the monetary policy instruments at its disposal and the workings of the banking system.