The Fed's Dilemma: Preventing a Banking Crisis vs. Curbing Inflation

Banking Crisis Looms

According to Klaros Group, a financial consulting firm, hundreds of banks are at risk of failure this year. This follows the 2009 crisis where 140 banks failed. While this is primarily viewed as a threat to individuals and communities, it could quickly escalate into a larger issue for the economy. This is particularly concerning in an economy grappling with high inflation and an overreliance on ultra-low interest rates.

Small Banks at Risk

The majority of the banks at risk are smaller institutions with assets under $10 billion, although a few larger regional banks are also in danger. Some of these banks might be able to avoid closure by halting expansion plans or offering fewer services. Others might merge with larger banks. However, with inflation too high for the Fed to cut now, a "higher for longer" interest rate policy seems increasingly likely. This puts banks with high exposure to troubled commercial real estate at particular risk of initiating a domino effect of small collapses leading to larger ones, potentially resulting in a real estate crisis.

The Klaros Report

The Klaros report examined community banks with a large proportion of troubled commercial real estate loans, uninsured deposits, and significant losses on other loans and bonds. These banks are held hostage by higher interest rate policy. Federal Reserve Chairman Jerome Powell has acknowledged that not all of these banks will survive. However, he also assured that a few failures won't lead to an uncontrolled downward spiral.

Fed's Assurance

According to Powell, the Fed is working with these troubled smaller banks that are sitting on loans for vacant office and retail buildings. However, interpreting his statements is tricky. If he believed that bank failures in 2024-2025 would start a domino effect, he wouldn't say so to avoid causing market panic and potentially triggering a self-fulfilling prophecy.

The Fed's Promise

Powell has promised that the Fed will use taxpayer money to protect the megabanks deemed "systemically important" if its economic meddling leads to a banking crisis. The first bank failure of 2024, First Republic Bank, doesn't fall into this "too big to fail" category and was absorbed by the larger Fulton Financial. Almost 50% of First Republic's loans were in commercial real estate.

The Fed's Dilemma

The Fed is caught between preventing a banking crisis and preventing inflation from spiraling out of control. It needs higher rates to reduce inflation, but key sectors of the economy that rely heavily on lending cannot survive in a higher-rate environment. In a free market, interest rates would be much higher, and "too-big-to-fail" banks wouldn't exist.

Conclusion

Without the free market's self-regulating mechanisms, where losers are allowed to lose regardless of their size, the Federal Reserve's interventions lock America into a seemingly endless cycle of recession and bubble, boom and bust. However, every cycle tightens the spring more as the Fed postpones an all-out failure of the system and the dollar itself in the long term.

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