Fed Faces Dilemma: Inflation or Financial Stability?

The recent banking crises at SVB and Credit Suisse have brought to the forefront concerns about financial stability. Some people may attribute these crises to mismanagement, but there are clear indications that the impact of the crises may have long-term effects on the system. This is particularly worrisome because higher interest rates could ripple through the system, exacerbating the situation.

When it comes to making decisions, the Federal Reserve [Fed] must weigh the risks of inflation and over-employment against the risks of financial stability. In this case, financial stability seems to be the greater threat. This is evident from the actions of the Fed and the Treasury, who are moving to remove financial system risk.

There is currently hesitation to hike at the Fed because of the recent banking crises. Big bank failures may become more of a component of Powell's "totality of data" when making decisions. This is because financial stability is a crucial factor, and big bank failures may cause a ripple effect throughout the system. If this were to happen, it could lead to tighter financial conditions, making it more challenging for businesses and individuals to access credit.

The Bloomberg US Financial Conditions Index provides a good indicator of how to envision the banking crisis. The index tracks the overall level of financial stress in the US money, bond, and equity markets to assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms. The sharp drop in the index shows that financial conditions are becoming tighter, which is a cause for concern.