How the Fed’s inflation battle fueled banking turmoil, in 7 charts

That puts the Fed in a very difficult position this week as officials meet to figure out what level of rate hikes can continue to lower inflation without breaking the banking system. They must manage two threats to the economy: inflation and bank stability.

After the collapse of the Silicon Valley Bank, Washington asks: Is it to blame?

How exactly did we get here? Here’s seven charts showing how the Fed’s battle against high prices has contributed to instability in the banking sector.

1. Prices started rising early in the pandemic – and have continued to rise.

The economy virtually ground to a halt when covid broke out in March 2020. More than 20 million workers lost their jobs. Schools, restaurants, gyms and countless other businesses closed their doors. Everyone was ordered to stay at home.

As a result, the economy plunged into a deep recession.

By the time things reopened — and people started spending again, armed with new stimulus funds — there were major shortages, supply chain grunts, and production breakdowns that fueled inflation. Demand for goods shot up, while supply remained under pressure. The result: higher prices.

But the Fed did not act. Policymakers, including the president, firmly believed that inflation was temporary and would resolve itself once the pandemic-related shocks calmed down.

It wasn’t until December 2021, when inflation hit a 40-year high of 6.8 percent, that Fed officials started talking about rate hikes. They finally did—by a modest quarter of a percentage point—in March 2022. By then, prices had risen a whopping 9 percent from the previous year.

Timeline: US policymakers misjudged the threat of inflation until it was too late

2. The Fed tried to catch up by aggressively raising rates.

Since then, the central bank has raised interest rates seven more times, aiming to slow the economy enough to curb inflation.

But a number of new complications — including the war in Ukraine, which led to higher gas and energy costs — forced the Fed to redouble its efforts. Any increase in interest rates was a shock to the economy, although it was not immediately clear what the end result would be.

3. The Fed’s actions led to higher borrowing costs.

The central bank only controls one interest rate: the Federal Funds rate, which is what banks use to lend each other money overnight.

That percentage has skyrocketed from nearly zero to about 5 percent in the past year, the fastest increase ever.

And it won’t be long before banks pass those higher borrowing costs on to customers: mortgages, business loans and other types of loans have all become more expensive in the past year.

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4. Bond market sees largest drop ever recorded in 2022

Bonds, which are loans to a company, or in this case the government, usually pay a fixed interest rate and are seen as safe and reliable investments.

And while the Treasury Department always issues a lot of bonds, it has issued even more over the past 10 years, because that’s how the US government finances expensive projects. Trump tax cuts. Pentagon budget. Covid-era stimulus programs to support the economy under Trump and Biden.

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But as interest rates rose, investors were more interested in new bonds that promised to pay more, and long-term bonds tied to older, lower interest rates became less desirable — and therefore less valuable.

As a result, the bond market took a nosedive last year and recorded its strongest decline.

5. That was bad news for banks like the SVB, which had invested heavily in fixed-income bonds.

In recent years, banks — recently inundated with additional deposits from savings and pandemic-era stimulus — have expanded into bonds and other fixed-income investments, such as mortgage-backed securities. At SVB, fixed-income securities made up almost 60 percent of the bank’s assets at the end of 2022.

But when the Fed raised interest rates, those bonds lost value. SVB’s portfolio of $91 billion long-term securities was worth just $76 billion by the end of 2022. That $15 billion gap was much larger than the $1 billion shortfall the company reported a year earlier.

In addition, the vast majority of the bank’s deposits — nearly 94 percent — were uninsured, according to data from S&P Global. The national average is about half, making SVB particularly vulnerable to fears of a run becoming self-fulfilling. The bank’s customers withdrew $42 billion in just 24 hours, leaving the bank with a negative balance of $1 billion.

“It’s simple: When interest rates rise, bond values ​​fall,” said Darrell Duffie, a professor of management and finance at Stanford University. “Silicon Valley Bank had a lot of bonds — both government bonds and mortgage bonds — so when the Fed raised interest rates to reduce inflation, the value of all those bonds fell.”

That wouldn’t have been a big deal if SVB could have held on to its bonds until they came to maturity. But with a rush of depositors clamoring to get their money out of the bank, SVB had no choice but to sell its securities at a huge loss. The bank quickly collapsed.

“It was a classic bank run,” said Duffie.

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6. Countless other banks are still sitting on billions in devalued government bonds.

SVB was not the only one with its stock of declining bonds. US banks are sitting at a staggering $620 billion in unrealized losses, according to the FDIC.

The Federal Reserve intervened last week with an emergency program that allows banks to exchange devalued bonds for their original value in cash. While this offers a temporary solution, economists say there may be other unforeseen problems lurking in the financial sector.

“So far we’ve been able to avoid major spillovers — the central bank and others have come up with quick fixes to prevent this from spreading to a broader banking crisis,” said Dana Peterson, chief economist at the Conference Board. “But more shoes could still fall.”

The Fed has moved quickly to deal with a broader financial crisis by launching a new emergency lending program with generous terms to complement its existing emergency lending “discount window.” The measures are gaining ground with the banks so far Over-the-counter lending hit an all-time high of $153 billion last week.

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The swirling events of the past week and a half have raised new questions about the Fed’s next move.

The European Central Bank last week stuck to its aggressive plan to raise interest rates for the eurozone by half a percentage point despite troubles for Swiss behemoth Credit Suisse, forcing the bank to borrow up to $54 billion from the Swiss National Bank.

Many pundits and investors still expect the central bank to raise interest rates another quarter of a percentage point when it meets on Wednesday, though concerns are growing that the financial system is too fragile to handle the higher rates.

That’s a sharp reversal from earlier this month, when Fed Chairman Jerome H. Powell outlined the possibility of raising interest rates by half a percentage point, citing stronger-than-expected inflation and employment data. The economy provided more than 800,000 jobs in the first two months of this year and inflation remains high, with prices 6 percent higher than last year.

But all of that is now in the rearview mirror as investors worry about the potential cascading effects of bank failures and increased market stress.

“The Fed still wants to raise rates a bit more,” said David Donabedian, chief investment officer of CIBC Private Wealth US. “It’s just a question of whether the volatility of the banking system will allow them.”