Pick Your Poison: More Banks in Peril or Prolonged Inflation

Federal Reserve Chair Jerome Powell and his colleagues have tried their best to signal their intentions to the market regarding rate moves. The path has been relatively clear since the spring of 2022 that inflation was the greatest of all evils, exceeding recession or even dreaded stagflation, characterized by slow growth, rising prices and increased unemployment.

The die had been cast: inflation was the target, and the Fed began a series of the fastest rate increases since the early 1980s. 

Poison 1: Broad Banking Instability

But now, a new monster has emerged: broad banking instability, particularly for smaller and regional banks.

The dramatic increase in the balance sheets of the banking sector combined with the Fed’s rate increases have resulted in increased fragilities in the banking system.  These dynamics are likely to result in additional bank liquidity crises, shutdowns, acceleration in the consolidation of the banking sector, and, ultimately, meaningful challenges for the outlook of the U.S. economy, as lending at the local level would surely tighten.

More banks will experience increasingly larger number of unrealized losses on their longer maturity investments effectively eroding their capital base.  As customers seek greater yields on their cash deposits and elect to move into money-market or other higher-yield investments instruments, banks will scramble to align their investments and preserve liquidity in order to avoid a liquidity issue and crises of confidence.

What is not known is the psychological effect and poor optics of smaller community banks failing, and many customers, particularly individual depositors, small and mid-sized businesses, being exposed to losses that extend beyond FDIC insurance. 

The political pressure to backstop customers and engage in a large-scale, expensive and extensive bailout of small banks seems as unsavory and deleterious to the economy. 

Poison 2: Prolonged, Extended Inflation

Conversely, inflation has remained surprisingly stubborn. 

The Fed, already dinged as moving too slowly to combat inflation, will lose credibility in the seriousness with which it signaled was its primary job. 

While a temporary pause in rate increases may help quell banking instability, it only extends the pain of inflation longer and the likely poison for the Fed to pick.