Fed’s Problems Should Alarm Everyone

In response to the sudden collapse of Silicon Valley Bank, André Esteves, an executive in the Brazilian banking industry, said that any banking intern in Latin America would have known that Silicon Valley Bank had an interest rate risk.

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From a region that has experienced no shortage of banking-related problems, this statement may seem rather rich to some. The sentiment expressed by Esteves, however, is revealing, as it reflects growing concerns around the world about the Federal Reserve's policymaking and the adverse impact it may have on other countries.

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I believe that we should be concerned for a number of reasons. The Fed has mishandled the interest rate hike cycle over the past three years, faced insider trading allegations, stumbled with bank supervision, and, by being inconsistent in communicating, has fueled rather than calmed market volatility several times over the past three years.

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Despite these shortcomings, U.S. inflation has remained too high for too long, robbing people of purchasing power and particularly hard on the poor, which is causing these failings to become increasingly consequential for the public. As a result of the bank collapses last month, the authorities were deemed sufficiently serious enough to "break the glass" by triggering the "systemic risk exception". However, this response could impose a greater burden on all depositors than it was previously.

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There has been an increase in the risk of the U.S. falling into a recession as a result of recent developments, including the threat of less credit availability, fueling income insecurity in what would otherwise be viewed as a healthy economy.

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Everyone should be worried about the problems the Fed is facing. It is important to note that a loss of credibility directly impacts its ability to maintain financial stability and guide markets in a manner consistent with its dual mandate of ensuring that price stability and maximum employment are maintained. As an individual, I cannot recall a time when so many former Federal Reserve officials have been so critical of the institution's economic projections, which in turn influence the way the institution's monetary policy is developed and implemented.

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Last October, Edward Luce of the Financial Times embodied the mood well when he wrote an editorial with the headline, "The world is getting tired of the Fed." He commented that the world is beginning to resent the Fed because of its failures (and their adverse global spillovers).

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Recently, the Swiss officials responsible for the forced sale of Switzerland's second-largest bank told a press conference that the failure of SVB contributed to the difficulties that they were having in dealing with the forced sale of this bank.

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I cannot recall a time when the Fed’s forward guidance has been so dismissed by markets as it is now. Market expectations and the Fed's stated interest-rate trajectory have diverged by a full percentage point since the end of last year. Markets continue to price in a rate cut as early as June, despite everything they have heard and read about the Fed. That is a remarkably large gap for the central bank at the center of the global financial system.

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A lack of consistency in Fed communication has not helped either. According to recent research, market volatility during Jerome Powell’s press conferences tends to reverse the market’s initial reactions to the Committee’s statements, and these press conferences tend to be three times more volatile than those held by his predecessors.

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There is no wonder why the yield curve has seen extreme moves within the region heavily influenced by the Federal Reserve, as well as the other sections of the yield curve, which form the basis for a variety of financial activities both domestically and internationally. The yield on the two-year U.S. Treasury bond TMUBMUSD02Y, 3.990% has been trading in an unusual range of 1.5 percentage points in the last few weeks, sparking talk — and not just within the specialized financial media — about “bonkers bond trading.”

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I keep making the same mistakes over and over again

Earlier Fed errors led to these divergences. Once the Fed had finally retracted its belated “retirement” of the misdiagnosis of inflation after persisting in calling it “transitory” throughout 2021, it failed to act promptly. Consequently, four consecutive 0.75 basis-point hikes were ultimately necessary to slam on the brakes.

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It cannot be denied at this point that the world's most powerful central bank has lapsed in its analysis, forecasts, policy-making and communication. It has made a serious mistake in its analysis, forecasts, policymaking and communication. There is good news, however, that the Fed can still do well if it adopts a better strategic approach for its analysis and actions, addressing two major structural problems in addition to adopting a better strategic approach.

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As a result of groupthink, the Fed's decision-makers appear not to have the diversity of viewpoints and comprehensive expertise that other major central banks seem to have. To make the Fed's policymaking committee even more independent, they should follow the example of the Bank of England by adding two independent external voting members.

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Second, there is the problem of basic accountability. The Fed chair does appear before Congress twice a year, however those hearings do not facilitate the focus on what's really important: Fed policy design and implementation. As part of the due diligence process, experts in the field should also be contacted by Congress before regular testimony, as another layer of due diligence needs to be added.

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It has been widely debated whether the Powell-led Fed will go down in history as a consequence of its success in taming inflation, or whether it will be remembered as a consequence of the (Paul) Volcker Fed having conquered inflation, or as a consequence of the (Arthur) Burns Fed having brought stagflation to the country.

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It is my fear that this could end up being remembered as having undermined America's credible role as the anchoring power in the global economy at the center as well as its own political autonomy. As the Fed undermined its own credibility and political autonomy, I worry as well for America's role as the anchoring power.

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