Silicon Valley Bank failure complicates Fed’s job to slow inflation to 2%

The failure of Silicon Valley Bank (SVB) on March 10 and the subsequent closure over the weekend of Signature Bank led to fears of a widespread deposit run at smaller regional banks — many of which are still large banks — where a large percentage of deposits are above the FDIC deposit insurance cap of $250,000. Moreover, impacted firms would potentially have difficulty meeting payroll and other payment obligations, with adverse ramifications beyond the banking sector. The concentration of tech-sector firm's deposits at SVB made this a particularly acute problem for the tech sector and venture capital ecosystem.

To address these concerns and provide ample liquidity to allay depositors' fears that they would not be able to access all their funds or suffer losses, the FDIC, Federal Reserve and US Treasury over the weekend implemented a plan with three key elements:

• They extended the deposit insurance to all deposits at the two banks and pledged the funds would be accessible on Monday March 13.

• They established the Bank Term Funding Program (BTFP) allowing all depository institutions to borrow at the Fed a low rate with standard collateral used in open market operations.

• They allowed that collateral to be valued at par rather than marked to market as would have been the case in other Fed liquidity facilities. This raised the amount of borrowing power these banks now have in the wake of significant increases in Treasury yields over the past year or so, and prevents them from having to sell these assets, in which case they would realize losses on their balance sheets and be weakened financially, potentially stoking deposit outflows.

The heightened recognition of the stresses that led to their failures shifted financial market sentiment to a decidedly risk-off posture late last week and early on March 13, as evidenced by broadly-based stock price declines, especially for regional banks, and sharp jumps in US Treasury securities prices and declines in yields as investors sought default-risk-free US Treasuries as a safe haven.

Markets calmed as the lack of news of widespread deposit withdrawals suggested the plan was stemming such withdrawals. Stock prices then rose, ending higher on the day, and Treasury yields reversed some of their earlier declines.

Implications for monetary policy

The Federal Open Market Committee (FOMC) raised the target for the federal funds rate by ¼ percentage point, to a range of 4½% to 4¾%, on Feb. 1. February's rate hike followed a sequence of four consecutive super-sized increases of 75 basis points, and a 50-basis point hike last December, as the Fed began to slow the pace of hikes.

Since March of 2021, the target for the federal funds rate has been increased by 4½ percentage points, the steepest trajectory since the early 1980s. Since the Feb. 1 rate hike, a spate of strong data for January and comments by Fed policy makers, and notably Chair Powell, had boosted expectations that March's policy meeting could see a 50 basis point increase in the Fed funds rate target range.

With inflation remaining well above the Fed's 2% target and the Fed's commitment to returning inflation to near 2% steadfast, we should expect increases in the policy rate to continue. If the recovery and staibilization of regional bank share prices holds and economic data come in broadly as expected in coming days, the Fed is likely to want to demonstrate that it can work to preserve financial stability while continuing to implement policies designed to squeeze inflation back toward its 2% target. This would suggest going ahead with a 25-basis-point rate rise next week.

Ultimately, we continue to expect to see the upper end of the target range for the federal funds rate rise to 5.50%, and to remain there into early 2024, as the FOMC waits for convincing evidence that inflation is on track to decline to 2% on a sustainable basis. The financial instability following the failure of SVB somewhat reduces the odds that all three projected rate increases will in fact occur and raises the odds of an earlier policy reversal.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.