On the one hand an impending banking crisis, on the other hand persistent inflation. Such is the unenviable position of Federal Reserve Chair Jerome Powell. Powell would do well to recognize how the Fed’s monetary policy is leading to a banking crisis and make a course correction. Or the US economy faces a prolonged winter.
Fortunately, there is a roadmap to get out of this crisis before it turns into a macroeconomic meltdown – the way India has dealt with the economic impact of the COVID-19 pandemic.
First, it’s important to understand why the Silicon Valley Bank fiasco is the canary in the coal mine. The Fed’s most aggressive rate hike in four decades – from 0 percent to about 5 percent in just six months – sparked this crisis.
Post-pandemic, US commercial bank deposits grew from about $13 trillion to $18 trillion, as shown in the chart below. However, that $5 trillion increase in deposits was accompanied by a mere $2 trillion increase in lending. The banks flowed into cash and invested in securities.
Crucially, investment in Treasury and agency securities increased by $1.3 trillion; around half of these have a term of more than 10 years. Longer-dated securities are much more sensitive to changes in interest rates. As a result, the Fed’s rapid rate hike caused these securities to fall sharply.
The FDIC estimates that unrealized losses on securities exceeded $600 billion. In December, total US commercial bank equity was $2.2 trillion. That $600 billion loss was equivalent to 30 percent of banks’ equity. This will inevitably result in several banks becoming insolvent as their equity is wiped out. Given this, the possibility of a widespread banking crisis is real.
The Fed must recognize that further monetary tightening will only exacerbate the banking crisis. Additionally, since a credit crunch has long-term and detrimental effects on economic growth, raising interest rates is a very dangerous option.
Despite facing stubborn inflation – core inflation remains stubborn as March data showed – US policymakers are having to swallow the pill that monetary tightening must end immediately. Otherwise, the side effects of the banking crisis could lead to corporate failures and another round of bank failures, halting the flow of credit and slowing growth for several quarters.
If the option of monetary tightening were removed from the table, US policymakers would benefit from studying and learning from India’s economic policy response during COVID. Having helped shape the policies that have helped India successfully navigate the crisis, I can outline some lessons that will be valuable for US policy today.
India entered the COVID pandemic in a bad place. Rating agencies had downgraded our country’s credit prospects. India’s country rating was just one notch above non-investment grade. If Delhi had decided to counteract the economic damage from COVID by simply throwing money around, it could have resulted in a downgrade to non-investment grade, triggering capital flight. At the same time, India has had to cushion the economic impact on the poor and vulnerable.
We knew from experience during the Great Recession that over-reliance on demand-side action was not the solution either. This resulted in double-digit inflation every month for 18 months, with India becoming part of the Fragile 5 economies. Recognizing early on that the crisis would severely impact supply, India has taken supply-side measures. Delhi geared its tax policy towards infrastructure development, enacted reforms to alleviate corporate structural problems, and provided incentives for companies to increase production in critical sectors.
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As a result, inflation in India, at 6.4 percent in February this year, is below the historical average of 7.5 percent and within the country’s inflation target. Also, India expects growth of 7 percent this decade. This robust economic performance is due to a smart balance between demand and supply side measures during the COVID crisis.
As Fed Chair Powell and other US policymakers struggle to respond to the current banking crisis, they recognize that there is no silver bullet for the US economy. It will take a smart balance of politics and patience to ensure the current banking crisis does not spread to the whole system and the economy at large. The good news is that India’s successful management of its own recent crisis offers a way forward.
Krishnamurthy Subramanian is Executive Director (India) of the International Monetary Fund and served as India’s Principal Economic Adviser from 2018 to 2021.
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