What goes up must come down: Federal Reserve Board Chair Jerome Powell leaves a news conference in Washington. The Fed’s hiking cycle contributed to the sudden collapse of tech
lender Silicon Valley Bank recently. Photo: Saul Loeb/AFP
When the Federal Reserve started to tighten its grip on US credit a year ago, analysts warned that eventually something would have to give. On 10 March, something did: tech lender Silicon Valley Bank (SVB) suddenly collapsed, triggering fears of more far-reaching fallout.
SVB’s plight conjured panic that the world economy was in for a repeat of the 2008 global financial crisis, which ushered in a decade of historically low interest rates in the US and elsewhere. In an event that seemed to confirm the worst, less than a week later, shares in Switzerland’s second-largest bank, Credit Suisse, plummeted.
These deep shocks to the banking sector, which some say were inevitable given aggressive hiking cycles, exposes the dependency of advanced economies on cheap credit.
The Fed’s medicine for the recession that followed the 2008 crisis was, in some ways, the same as its cause: low interest rates.
After the 2001 recession, the Federal Open Market Committee maintained a low federal funds rate, which contributed to the massive expansion of the real estate market. US interest rates were kept at a historically low level until June 2004, when the Fed began raising rates.
Emboldened by the housing boom, lenders offered home loans to individuals with poor credit. The number of subprime mortgages originated nearly doubled from 1.1 million in 2003 to 1.9 million in 2005, according to Fed research.
Though monetary conditions in the world’s largest economy were at the heart of the crisis, commentators said global factors had been building towards a crash.
Fed chair Ben Bernanke flagged these factors in a speech in 2009, saying the crisis was impossible to understand “without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s”.
The period leading up to the crisis was characterised by unusually low inflation and interest rates globally and generally strong economic performance. The economic volatility associated with boom and bust cycles had seemingly subsided.
But the US had run into trade pressures after increased household demand triggered substantial growth in imports. A big factor in the trade imbalance that ensued was China, which became one of the fastest growing suppliers of US goods imports. China had got a leg up in the export market by using its low-paid workforce, an advantage of having an under-valued currency, to ramp up production. America’s trade hegemony had previously allowed it to soak up price inflation.
The equilibrium achieved during the great moderation was about to be thrown off by three apparently unsustainable factors: a real estate boom, underpinned by bad credit, trade pressures, as well as a large Bush-era fiscal deficit. And so it was.
Crash course
After having almost doubled in the decade prior, home prices began to fall in 2007 as demand dried up amid rising interest rates. The Fed had grown more uncomfortable with inflation.
Falling home prices sparked an increase in mortgage defaults and delinquencies. By the second quarter of 2008, according to the Fed, the share of seriously delinquent mortgages had surged to 4.5%. Foreclosures increased from roughly 650 000 in the first half of 2007 to about 1.2 million in the first half of 2008.
Lehman Brothers was the first big crack to indicate a pipe had burst. The fourth-largest US investment bank filed for bankruptcy on 15 September 2008 over the subprime mortgage crisis, while insurance giant American International Group (AIG) was on the brink of collapse.
In the last quarter of 2008, US GDP plummeted 8.4% and the economy lost more than 1.9 million jobs. The Fed responded by providing historic liquidity support to banks in the US and in Europe. Considered too big to fail, it bailed out AIG for $182.3 billion in total.
The medicine
To prevent a collapse in credit, the Fed cut interest rates near zero, where they stayed until the start of a moderate hiking cycle at the end of 2015. Economic weakness in the US persisted and the Fed provided additional support through quantitative easing.
In the years that followed the global financial crisis, the US and other advanced economies kept inflation at bay. This was probably because the shock dealt to the banking sector had the effect of moderating lending in the years that followed.
This changed after Donald Trump became president. Trump-era tax cuts created a “sugar high”, as some economists put it, and his trade war with China, which saw the US impose tariffs on imports, caused inflation to climb.
In 2018 the Bank for International Settlements noted that a prolonged period of low interest rates might encourage asset bubbles and subsequent crashes. Low rates can diminish the resilience of banks by encouraging risk-taking, thus increasing the risk of future losses. And, even in the absence of greater risk-taking, a future surge in interest rates, or “snapback”, could be challenging for financial institutions.
A prolonged period of low interest rates encourages risky behaviour by banks because it impacts returns on certain assets, said Bureau for Economic Research chief economist Hugo Pienaar. They tend to turn to riskier assets in order to derive higher returns.
Snapback
Low interest rates tend to create asset price bubbles, especially when there is an expectation that the cost of borrowing is going to remain low for a long time.
“If you keep interest rates too low for too long and the fundamentals in your economy do not justify that — in other words economic activity is robust, the job market is robust and you may be running into some inflationary issues — then of course it is not a good idea. You should try and tighten policy,” Pienaar said.
“This is of course the ‘problem’ in the US economy in that it was doing reasonably well, but it didn’t have inflation. So the Fed could sort of justify keeping rates low.”
America’s hiking cycle in the latter half of the 2010s was interrupted by the Covid-19 pandemic, which prompted central banks around the world to cut interest rates and many central banks kept them low even when inflation started heating up in 2021.
Until 2022, advanced economies had not experienced anything close to a snapback.
For SVB, the Fed’s hiking cycle — considered the most aggressive since that of former Fed chair Paul Volcker 40 years ago — spelled its end. The bank had benefited significantly from ultra-low interest rates, which saw billions being pumped into it through tech venture capital.
Like other banks during the prolonged period of low-interest rates, SVB put money into long-term US treasury bonds, which are usually viewed as a safe-haven asset. The dramatic increase in interest rates caused the value of those bonds to depreciate significantly.
The turmoil at Credit Suisse, which resulted in the bank’s fire sale to UBS, was slightly different. The Swiss giant said it had found “material weaknesses” in its internal controls over financial reporting, shaking shareholder confidence.
Michael Power, a strategist at NinetyOne asset management, said the financial system had created a dependency on ultra-low interest rates in 2008’s aftermath. For the core of the Western system (Japan, Europe, the UK, the US, Canada) this dependency is unhealthy. The financial system “was like a drug addict that had become addicted to low interest rates”, Power said.
“There was no inflation in the system, so it was alright to do that at the time, but as soon as inflation came back, central banks were obliged to start raising rates to keep the lid on prices. This basically told the drug addict, ‘I’m sorry your drugs are going to cost more.’”
On Wednesday, the Fed raised interest rates by a quarter of a percentage point but signalled a pause in more hikes.