Chapter 1: The Federal Reserve's Influence

The Federal Reserve is convening this week to deliberate on the potential for further interest rate hikes following six increases in the past ten months. With inflation still alarmingly high, a rate increase may seem justified. However, these elevated rates are contributing to bank failures, raising questions about whether more hikes are prudent. The current economic predicament is largely attributable to the Fed's actions.

In early 2021, it was clear to any unbiased observer that inflationary pressures were intensifying within the economy. Historically, the Fed has acted preemptively against inflation to prevent it from spiraling out of control, aiming to maintain a target inflation rate of 2% to 3%. This would translate to a monthly Consumer Price Index (CPI) change of approximately 0.1% to 0.2%, leading to an annual CPI around 2%. However, in January 2021, the CPI rose by 0.3%, followed by 0.4% in February, 0.6% in March, and 0.8% in April. These figures indicated a clear trend of increasing inflation, particularly when considering the federal government’s escalating deficit spending.

In 2020, the government recorded a deficit of $3 trillion, and in 2021, the Biden Administration planned another deficit of $3 trillion, significantly exacerbating the inflation issue. Yet, the Fed took a startlingly reckless stance, labeling the inflation as temporary, using the term "transitory." Historically, inflation is rarely temporary except in extraordinary circumstances such as war or famine.

Throughout 2021, the Fed maintained its expansive bond-buying program, which increased the money supply and stimulated an already overheated economy growing at a rate of 6%. This expansionary approach continued into 2022, until March when the bond-buying was halted, and interest rates were incrementally raised by 25 basis points. This minor adjustment did little to curb inflation, which soared to 9.1% by June, as per the CPI.

The vast majority of this inflation stemmed from excessive government spending and the Fed's imprudent monetary policies. Had the Fed initiated interest rate increases a year earlier, in March 2021, the subsequent hikes would likely have been smaller and more gradual, potentially halving the current inflation rate.

The Fed must accept complete accountability for the existing inflation crisis. Furthermore, it bears partial responsibility for the recent bank failures. While the specific reasons behind each bank's collapse are still being investigated, the rapidly increasing interest rates likely played a significant role.

In June 2022, with the annual CPI at 9.1%, the Fed finally acknowledged that price stability was indeed one of its objectives. After a year and a half of neglecting inflation, Chairman Powell stated post-meeting, "Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone."

Over the following ten months, interest rates surged from near zero to 4.5%, marking the fastest increase since 1980. Consequently, yields on Treasury bonds jumped from around 1.5% to over 4%, contributing to bank failures.

One notable casualty was Silicon Valley Bank, marking the second-largest bank failure in history, which faced significant liquidity issues. In the U.S., the fractional banking system means that most deposits are not actually held by banks; rather, they lend out a portion of funds and invest in long-term government bonds. SVB had a substantial portfolio of low-yield, long-term government bonds, mistakenly believing that any interest rate increases would be gradual, allowing time to adjust their bond holdings.

However, as their major depositors faced declining revenues and withdrew substantial amounts from their accounts, SVB was forced to liquidate assets to meet these withdrawals. With interest rates having tripled, they had to sell their low-yield bonds at substantial discounts, leading to a plummet in the value of their bond assets, ultimately resulting in the bank's failure.

Had the Fed acted judiciously in 2021, inflation would likely have been significantly lower, and the banking system would not be facing such turmoil. Instead, the Fed's decisions have perpetuated the current economic crisis.

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