Low Rates Were Meant to Last. Without Them, Finance Is In for a Rough Ride.
WASHINGTON — If a number defined the 2010s, it was 2 percent. Inflation, annual economic growth, and interest rates at their highest all hovered around that level — so persistently that economists, the Federal Reserve and Wall Street began to bet that the era of low-everything would last.
That bet has gone bad. And with the implosion of Silicon Valley Bank, America is beginning to reckon with the consequences.
Inflation surprised economists and policymakers by spiking after the onset of the coronavirus pandemic, and at 6 percent in February, it is proving difficult to stamp out. The Fed has lifted interest rates by 4.5 percentage points in just the past 12 months as it tries to slow the economy and wrestle price increases under control. The central bank’s decision next week, on March 22, could nudge rates even higher. And that jump in borrowing costs is catching some businesses, investors and households by surprise.
Silicon Valley Bank is the most extreme example of an institution being caught off guard so far. The bank had amassed a big portfolio of long-term bonds, which pay more interest than shorter-term ones. But it wasn’t paying to sufficiently protect its assets against the possibility of an interest rate spike — and when rates jumped, it found the market value of its holdings seriously dented. The reason: why would investors want those old bonds when they could buy new ones at more attractive rates?
Those impending financial losses helped to spook investors, fueling a bank run that collapsed the institution and sent tremors shooting across the American banking system.
The bank’s mistake was a bad — and ultimately lethal — one. But it wasn’t wholly unique.
Many banks are holding big portfolios of long-term bonds that are worth a lot less than their original value. U.S. banks were sitting on $620 billion in unrealized losses from securities that had dropped in price at the end of 2022, based on Federal Deposit Insurance Corporation data, with many regional banks facing big hits. Adding in other potential losses, including on mortgages that were extended when rates were low, economists at New York University have estimated that the total may be more like $1.75 trillion. Banks can offset that with higher earnings on deposits — but that doesn’t work if depositors pull their money out, like in Silicon Valley Bank’s case.
“How worried should we be comes down to: How likely is it that the deposit franchise leaves?” said Alexi Savov, who wrote the analysis with his colleague Philipp Schnabl.
Regulators are conscious of that potentially broad interest rate risk. The Fed unveiled an emergency loan program on Sunday night that will offer banks cash in exchange for their bonds, treating them as though they were still worth their original value in the process. The setup will allow banks to temporarily escape the squeeze they are feeling as interest rates rise.
But even if the Fed succeeds at neutralizing the threat of bank runs tied to rising rates, it is likely that other vulnerabilities grew during decades of relatively low interest rates. That could trigger more problems at a time when borrowing costs are substantially higher.
“There’s an old saying: Whenever the Fed hits the brakes, someone goes through the windshield,” said Michael Feroli, chief economist at J.P. Morgan. “You just never know who it’s going to be.”
America has gone through regular bouts of financial pain brought about by rising interest rates. A jump in rates has been blamed for helping to burst the bubble in technology stocks in the early 2000s, and for contributing to the decline in house prices that helped to set off the massive crash in 2008. Even more closely related to the current moment, a sharp rise in interest rates in the 1970s and 1980s caused acute problems in the savings and loan industry that ultimately ended only when the government intervened.
There’s a simple logic behind the financial problems that arise from rising interest rates. When borrowing costs are very low, people and businesses need to take on more risk to earn money on their cash — and that typically means that they tie up their money for longer or they throw their cash behind risky ventures.
When the Fed raises interest rates to cool the economy and control inflation, though, money moves toward the comparative safety of government bonds and other steady investments. They suddenly pay more, and they seem like a surer bet in a world where the central bank is trying to slow the economy.
That helps to explain what is happening in the technology sector in 2023, for example. Investors have pulled back from tech company stocks, which tend to have values that are predicated on expectations for future growth. Betting on prospective profits is suddenly less attractive in a higher rate environment.
A more challenging business and financial backdrop has quickly translated into a souring job market in technology. Companies have been making high-profile layoffs, with Meta announcing a fresh round of layoffs just this week.
That is more or less the way Fed rate moves are supposed to work: They diminish growth prospects and make it tougher to access financing, curb business expansions, cost jobs and end up slowing demand throughout the economy. Slower demand makes for weaker inflation.
But sometimes the pain does not play out in such an orderly and predictable way, as the trouble in the banking system makes clear.
“This just teaches you that we really have these blind spots,” said Jeremy Stein, a former Fed governor who is now at Harvard. “You put more pressure on the pipes, and something is going to crack — but you never know where it is going to be.”
The Fed was conscious that some banks could face trouble as rates rose meaningfully for the first time in years.
“The industry’s lack of recent experience with rising and more volatile interest rates, coupled with material levels of market uncertainty, presents challenges for all banks,” Carl White, the senior vice president of the supervision, credit and learning division at the Federal Reserve Bank of St. Louis, wrote in a research note in November. That was true “regardless of size or complexity.”
But it has been years since the central bank formally tested for a scenario of rising rates in big banks’ formal stress tests, which examine their expected health in the event of trouble. While smaller regional banks aren’t subject to those tests, the decision not to test for rate risk is evidence of a broader reality: Everyone, policymakers included, spent years assuming that rates were not going to go back up.
In their economic forecasts a year ago, even after months of accelerating inflation, Fed officials projected that interest rates would peak at 2.8 percent before falling back to 2.4 percent in the longer run.
That owed to both recent experience and to the economy’s fundamentals: Inequality is high and the population is aging, two forces that mean there are lots of savings sloshing around the economy and looking for a safe place to park. Such forces tend to reduce interest rates.
The pandemic’s downswing upended those forecasts, and it is not clear when rates will get back on the lower-for-longer track. While central bankers still anticipate that borrowing costs will hover around 2.5 percent in the long run, for now they have pledged to keep them high for a long time — until inflation is well on its way back down to 2 percent.
Yet the fact that unexpectedly high interest rates are putting a squeeze on the financial system could complicate those plans. The Fed will release fresh economic forecasts alongside its rates decision next week, providing a snapshot of how its policymakers view the changing landscape.
Central bankers had previously hinted that they might raise interest rates even higher than the roughly 5 percent that they had previously forecast this year as inflation shows staying power and the job market remains strong. Whether they will be able to stick with that plan in a world colored by financial upheaval is unclear. Officials may want to tread lightly at a time of uncertainty and the threat of financial chaos.
“There’s sometimes this sense that the world works like engineering,” Skanda Amarnath, executive director of Employ America, said of the way central bankers think about monetary policy. “How the machine actually works is such a complex and fickle thing that you have to be paying attention.”
And policymakers are likely to be attuned to other pockets of risk in the financial system as rates climb: Mr. Stein, for instance, had expected rate-related weakness to show up in bond funds and was surprised to see the pain surface in the banking system instead.
“Whether it is stabler than we thought, or we just haven’t hit the air pocket yet, I don’t know,” he said.
Joe Rennison contributed reporting.
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