To be hawkish, or not to be hawkish is the Fed dilemma

  • 17 Mar , 2023
  • 12:29 PM
  • With the fall of SVB Financial and a slew of others following, the latest challenge for the Fed is to keep the banking system robust and functioning. Will this change the tone of the Fed from too much hawkishness to moderate hawkishness?

Just about two weeks back, the Fed had a simple mandate. Recovery in growth was happening at a slow pace, Inflation remained elevated and strong employments levels were ensuring that consumer spending took longer to response to higher rates. In a matter of one week, the narrative has entirely changed. With the fall of SVB Financial and a slew of others following, the latest challenge for the Fed is to keep the banking system robust and functioning. Will this change the tone of the Fed from too much hawkishness to moderate hawkishness? We will come back to that later.

How SVB Financial went bust?

When SVB Financial folded up last week, two apparent reasons were seen for the collapse. The first was its huge exposure to the Silicon Valley start-ups. Nearly every third start-up and venture capital financier had a banking relationship with SVB. In the last one year, there has been a funding winter for start-ups (especially digital start-ups). This led to a cash crunch, forcing these start-ups to withdraw close to $41 billion from their deposits. That was unexpected and to pay these deposits SVB had to heavily resort to selling its bonds. Therein came the second problem. When deposits are demanded, it has to be a fire-sale of bonds. In the last 1 year, Fed rates are up 450 bps so bond portfolios are sitting on huge losses. In the case of SVB, due to the fire-sale, they had to book $1.8 billion loss and that hole did them in.

But things at SVB are not as simple as it appeared at first glance. It is increasingly becoming evident that much of what happened at SVB had to do with its own asset quality, internal policies and risk management. Clearly, SVB had fallen short on all these fronts. Here is some classic evidence.

  • SVB had adopted the compromise of business growth at the cost of compliance. To encourage the flow of start-up business, SVB had relaxed most compliance guidelines. For instance, the bank allowed start-ups to open a bank account even without a social security number. 

  • SVB did not comply with the FDIC insurance limits. Currently, the Federal Deposit Insurance Corporation only allows deposits to the tune of $250,000. However, in the case of SVB, there were more than 37,000 mid-sized start-ups with deposits above this FDIC imposed limit of $250,000. 

  • The result was that out of the total deposit base of nearly $175 billion that SVB had, nearly 90% of the deposits were not covered by the deposit insurance offered by the FDIC. This made depositing money with SVB extremely risky, but deposits did not mind.

  • All the Y-Combinator backed start-ups globally had an exposure to SVB, either in the form of deposits or loans or equity investments. This meant that the start-ups would be the worst hit in the event of any collapse of SVB Financial, which is what happened. 

All these factors gave SVB a unique edge over traditional banks in attracting start-up deposits. But it also exposed the banks and the depositors to undue risk.

Will Fed remain stoic after 3 bank failures?

In a matter of one week, 3 US banks went bust. Of these SVB Financial had a deposit base of $212 billion, Silvergate Capital had a small deposit base of $15 billion while Signature Bank had a deposit base of about $90 billion. The Fed swung into action when First Republic Bank with assets of $197 billion started sinking. That is when it syndicated a rescue plan with JP Morgan and Morgan Stanley infusing close to $30 billion as deposits into First Republic Bank. Then there was the special window for banks to borrow from the Fed.

Here is how the special window BTFP (Bank Term Funding Program) will work. Most banks in the US hold deposits backed by investments in government bonds. The problem is that 450 bps rate hike by the Fed would have substantially eroded the value of these bonds. That was the trigger for the collapse of SVB. It is estimated that the US banks, as a whole, had $650-$700 billion of potential bond losses in their books. That means any sale would mean booking losses and any funding would mean lower limits. To overcome these problems, the US Fed has started a special window wherein banks and financial institutions can borrow from the window by offering their bond holdings as collateral. The best part is that the funding will be done on the original value and not at the depreciated value due to bond losses.

That would mean a lot of liquidity infusion, but there is not much of a choice that the Fed has at this point. If the run-on banks continue, the potential bond losses would become actual losses causing huge losses to the banks and to the depositors. 

Will the US Fed go slow on rate hikes now?

Just a week back, the narrative was about moving quicker on rate hikes to fight inflation and strong labour data. Have things really changed in the last one week? Will the Fed start to reconsider its hawkish stance? For now, it looks like the Fed is keeping its hawkishness and liquidity separate. According to the Fed, the problems with banks like Signature Bank and SVB are more specific to the models adopted by such banks. However, that cannot be blamed on the Fed hawkishness alone because there are scores of other banks that are still sound. Yes, bond depreciation losses could be a challenge but that is what the BTFP (Bank Term Funding Program) of the Fed will address. The moral of the story is that the Fed intends to keep its hawkish monetary stance and its liquidity support to banks separate. It is unlikely to change the stance of the Fed for the time being. Hawkishness stays on.

Christine Lagarde suggested something similar

Similar statements were also made by Christine Lagarde, head of the ECB, after the 16th March meeting once again hiked rates by 50 basis points. In her post statement interview, Lagarde drew a fine line of distinction between inflation risk and financial risk and promised to keep the two separate. That is why, when Credit Suisse showed signs of stress, the Swiss National Bank agreed to give the bank funding to the tune of $54 billion. However, at the same time, the ECB also hiked the rates by a full 50 bps indicating that the ECB would continue to work to contain inflation as well as inflation expectations. So, neither the Fed, nor the ECB is giving up its hawkish monetary stance for now. However, it remains to be seen whether these central banks can maintain this stoicism, if the banking crisis worsens.

What does the RBI do now?

For now, the situation in India is well under control. Indian banks are not globally exposed like the US and European banks, so the RBI should have less of a problem. Also, Indian banking is largely domesticated so global forces will have less of an impact. That means the RBI can also afford to run a hawkish rate policy and a more lenient liquidity policy. In the event of any crisis, the RBI is also likely to rely more on liquidity management without changing its hawkish stance. But the bigger takeaway for the RBI and the Indian government is that it puts to rest the dilemma of financial risk versus inflation risk. For now, risk of contagion looks limited in India and any fallout of the SVB crisis can be manage through liquidity infusion alone. Battle against inflation via rate hikes is here to stay.

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Fed minutes hint that rates may go well beyond neutral zone

  • India Infoline News Service
  • 07 Jul , 2022
  • 10:20 AM
Fed has already hiked rates by 25 bps in March, 50 bps in May and another 75 bps in June; taking Fed rates higher by 150 bps in a quarter to the range of 1.50% to 1.75%. But the Fed is far from being done.

The FOMC minutes underline that the Fed is betting on a very high probability of 50 bps to 75 bps hike in July and September. In fact, now the choice in front of the Fed is between 50 bps and 75 bps in the next 2 meetings and may tone down after that depending on the rate of inflation. Not much change can be expected unless there is a drastic fall in inflation.

One important aspect of Fed policy was always going to be how much beyond the Fed neutral rate it will traverse in 2022. The Fed neutral rate is 2.5%, which is the rate up to which inflation can be controlled, without impacting GDP growth. Beyond that level, GDP takes a hit. In 2022, Fed plans to go at least 90 bps above neutral rate to 3.40% or more.

CME Fedwatch is hinting at 90-100 bps above neutral rate by 2022

CME Fedwatch captures probability of rate hikes at future meetings based on the yields implied in Fed Futures trading. Here are implied Fed rate scenarios over next 9 meetings.

Fed Meet 200-225 225-250 250-275 275-300 300-325 325-350 350-375 375-400 400-425 425-450 450-475
Jul-22 9.1% 90.9% Nil Nil Nil Nil Nil Nil Nil Nil Nil
Sep-22 Nil Nil 7.8% 79.5% 12.7% Nil Nil Nil Nil Nil Nil
Nov-22 Nil Nil Nil 5.1% 54.8% 35.7% 4.4% Nil Nil Nil Nil
Dec-22 Nil Nil Nil 1.5% 19.2% 49.4% 26.8% 3.1% Nil Nil Nil
Feb-23 Nil Nil Nil 1.1% 15.3% 42.7% 31.8% 8.3% 0.7% Nil Nil
Mar-23 Nil Nil Nil 1.1% 15.3% 42.7% 31.8% 8.3% 0.7% Nil Nil
May-23 Nil Nil 0.5% 7.4% 27.4% 37.9% 21.5% 5.0% 0.4% Nil Nil
Jun-23 Nil Nil 0.5% 7.4% 27.4% 37.9% 21.5% 5.0% 0.4% Nil Nil
Jul-23 Nil 0.3% 4.8% 19.8% 33.9% 27.7% 11.2% 2.1% 0.1% Nil Nil
Data source: CME Fedwatch

Apart from the regular hawkishness, there are some interesting trends emerging.
  • In the short term, the Fedwatch assigns a 91% probability of 75 bps rate hike in July FOMC meet and an 80% probability of another 50 bps rate hike in September 2022.
  • With Fed rates at 2.75% to 3.00% by September, the Fed is likely to push rates by another 50 bps in the November and December 2022 meetings.
  • In short, the Fedwatch expects to be 90-100 basis points above the neutral rate of 2.5% by end of year 2022; which is what even the Fed has been indicating.
  • There has been an interesting fall in the consensual long term rate forecast from 4.25% to a worst case scenario of 3.75%, including possibility of rate cuts in 2023.
  • While the story of Fedwatch is still one of front-loading rate hike, there is an increasing feeling that growth concerns may force a change of strategy in 2023.
For the first time, the Fedwatch has hinted at the possibility of a reversal in the rate hike cycle in 2023 if recession starts to pinch. That is an
interesting deviation.

Key takeaways from the minutes of June 2022 FOMC meeting

The FOMC minutes were announced at a time when the US economy is up against diverse forces. On the one hand, consumer inflation continues to be elevated at above 8%. On the other hand, the GDPNow indicator has given the first signs of 2 consecutive quarters of negative growth in the US real GDP. Here are the major takeaways from the FOMC minutes.
  1. If one were to summarize the FOMC minutes, there is not much of a change in the short term stance. The Fed is still prepared to hike rates by 50 bps or 75 bps in the July and September 2022 meetings. It has hinted at “more restrictive stance” if required.
  2. The FOMC focus, according to the minutes, was still on the need to fight inflation, even if it meant slowing the economy. That shows why the Fed consciously is willing to take the Fed rates even 90 to 100 bps above the neutral rate of 2.5% by the end of 2022.
  3. FOMC has maintained that it would not change policy tack unless inflation got closer to the targeted levels of 2%. While that may sound a steep target, a lot of that would have been achieved in the sharp fall in commodity prices in the last couple of weeks.
  4. Interestingly, the FOMC minutes has acknowledged that a grossly restrictive policy could come with a price but the committee was willing to adopt a restrictive stance to bring down 8% plus inflation. That could come at the cost of GDP growth.
  5. For the Fed it is not just about fighting inflation but also to be seen fighting inflation. In terms of Fed credibility, the June FOMC meeting rightly mentioned that Fed had to assure markets and the public that they were dead serious about fighting inflation.
  6. The dilemma between inflation and growth is likely to come up sooner rather than later. Real GDP of the US economy contracted by -1.6% in the March 2022 quarter and as per the Atlanta Fed GDPNow indicator, it looks all set to contract by -2.1% in June quarter.
  7. The sustained hawkish policy of the Fed, even at the cost of growth, has also created the anomalous situation of an inverted yield curve wherein the yields on the 2-year benchmark bond is higher than on the 10-year bond, hinting at a likely recession.
The gist of the FOMC minutes is that it remains hawkish for 2022, but could see a change of heart in 2023, should growth pressures escalate beyond a point.

What India must read from the FOMC minutes?

Should the RBI also follow a hawkish stance of monetary policy, like the Fed? In the Indian case, there are a number of imponderables. Firstly, inflation continues to be elevated in India too. However, the jury is still out on whether rate hikes are the answer to higher inflation that is supply driven. Also, the sharp fall in commodities in the last few weeks, should have moderated inflation.

We have a situation in the world, where many of the global economies are not yet buying the tightening argument. As of now, India still remains neutral. What remains to be seen is whether RBI continues its hawkish stance even after the 110 bps rate cut of the pandemic are reversed. The next few months will throw some interesting policy choices for India.

Central bank forward guidance; Is it an effective monetary tool?

  • India Infoline News Service
  • 20 Oct , 2022
  • 10:44 AM
Forward guidance refers to the practice of central banks giving outlook on how the central bank will handle interest rates and liquidity in the coming months and quarters. Normally, such guidance ranges from short term guidance of 1-2 quarters to long term guidance ranging from 3 years to 5 year.

In the Indian context, the RBI has used the rate action and the rate guidance combined to give a trajectory and to fine tune market expectations. While this has stood the test of time, some of the MPC members like Jayanth Varma have had reservations about such guidance. Varma has been consistently of the view that such guidance tends to tie down the central bank to a certain course of action and takes away their flexibility. Instead, experts like Varma have suggested a data-driven approach where decisions are based on current data.

The truth obviously lies somewhere in between. At a recent presentation organized by the Money Marketeers of New York University; Fed governor Michelle Bowman spoke at length about the role of forward guidance in setting the tone of monetary policy, its rules, applications and exceptions.

Explicit use of forward guidance as monetary tool

By explicit guidance we mean the guidance that is absolutely laid out in very specific terms. There is no scope for interpretation. Between March 2022 and September 2022, the US Federal Reserve hiked the rates by 300 basis points from the range of 0.00-0.25% to 3.00-3.25%. Through this process of increasing the rates, the Fed never left the markets in any degree of doubt. The Fed has hiked rates by 75 bps in the last 3 occasions and will mostly hike rates by another 75 bps in November. The guidance in all the cases was laid out well in advance and the Fed has stuck to that guidance.

According to Bowman, back in the first quarter of 2022, the Fed had underlined its stance that rates would be raised in tandem with the persistence of inflation. As inflation has persisted at above 8%, the Fed has been relentless in raising rates. This is notwithstanding the fact that the rates are already 50-75 bps above the neutral rate and there is a distinct possibility that the rate hikes would start to hit growth and even, perhaps, cause a mild recession in the US economy. The Fed has already guided that it was willing to go all the way to 5.25%, if warranted, by persistent inflation. In short, the future path is quite clear.

Inflation declining versus Inflation starting to decline

There is normally confusion about the tipping point when the Fed would change its stance from hawkish to dovish. Here again, as Bowman puts it, the Fed has given appropriate guidance. For instance, the Fed has drawn a subtle difference between Inflation falling and Inflation starting to fall. To quote Bowman, “If the Fed does not see signs that inflation is moving down, then sizable increases in the target range for the federal funds rate should remain on the table”.

Regarding the tipping point, Bowman has also added that “If inflation starts to decline, then a slower pace of rate increase would be appropriate”. The moral of this guidance is that the federal funds rate may even move up to a restrictive level and stay there for some time. Remember, here the guidance does not talk about the specific number but gives a picture of how the Fed would react to the data points.

Explicit forward guidance as a monetary tool

According to Bowman, explicit forward guidance is not about levels but about clarity to the markets of how the Fed would read data. The uncertainty on the inflation front makes it tough to provide precise guidance on the path for the federal funds rate. That is where explicit forward guidance can come with a “What If” scenario to give clarity. Here is what Bowman has to say about the role and relevance of forward guidance.

a)      According to Bowman, explicit guidance is about specific economic outcomes like 2% inflation, 4.5% unemployment, 3% growth in GDP etc. These will be the basis for forward guidance by the Fed.

b)      Forward guidance need not be explicit about future policy actions or the timing, but it can just describe likely policy actions by the FOMC as a reaction to data flows. Forward guidance here is essentially meant to influence public expectations.

c)      According to Bowman, if inflation has to trend lower in the long term, then the inflation expectations have to come down. That would come down only when people are confident that the central bank is relentless in fighting inflation. Guidance helps here.

d)      According to Bowman, explicit forward guidance is an adjunct tool to the actual policy action. For instance, it is not sufficient just to manage inflation with rates. It has to be burnished with an explicit guidance that can play the role of influencing and fine tuning long term expectations of the market on inflation, interest rates etc.

e)      According to Bowman, explicit forward guidance became more important in the aftermath of the global financial crisis of 2008. Post the GFC, global central banks have perennially used monetary policy to manage the forces of growth and employment. That had made forward guidance a lot more relevant in the post GFC period.

f)       A major concern about forward guidance is the alteration trade-off. Bowman explains this paradox in an interesting way. According to Bowman, if the forward guidance is changed too often, then it betrays a sense of policy ambivalence. On the other hand, if the central bank delays the guidance shift for too long, it may become redundant. Explicit forward guidance has a cost in the form of loss of flexibility, but that is a price worth paying, according to Bowman, as it improves the quality of communication.

Key takeaways for the RBI on explicit forward guidance

Unlike the Federal Reserve, the RBI does not provide explicit forward guidance. However, the RBI has focused a lot on communication with the RBI governor releasing a detailed statement after each policy and also fielding questions from senior bankers and the press. For example, post COVID, the RBI did give explicit guidance that it would keep the stance of the policy accommodative to revive growth, as long as it was required.

However, in the last few months, the markets have been in a state of flux. In May 2022, the RBI made a shift towards rate hikes and withdrawal of accommodation. However, its explicit forward guidance also states that the RBI would not allow the GDP growth to be hampered. Here the RBI guidance is at cross purposes, something that Jayanth Varma has frequently highlighted. Even IMF pointed to this anomaly in the RBI-MPC forward guidance.

What is the way out? One way is for the RBI to rely on statistical outcome targets. Like the Fed, the RBI can also look at explicit targets for growth, inflation, cost of funds and currency, that would signal a shift in the policy stance. Outcomes are much easier to understand than the mindset of the policymakers under abstract conditions. Making this change would, probably, make the forward guidance more valuable in the Indian context.


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  • 07 July, 2022 |
  • 9:49 AM

When the minutes of the June 2022 FOMC meeting were released on July 6, the one area of interest was the outlook on further rate hikes.

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