The Fed's Unpleasant Choice

Which is worse: more inflation or more turbulence?

The Federal Reserve faces a tough decision at its meeting that ends this afternoon: Should Fed officials raise interest rates in response to recent worrying data on the inflation and accept the risk of causing new problems for the banks? Or should the authorities suspend their rate hikes and accept the risk that inflation will remain high?

This dilemma is another reminder of the vast economic damage caused by the banking crises. In today's newsletter, I'll first explain the Fed's tough call, then look at one of the lessons learned from the current banking turmoil. Above all, this turmoil is a reminder of the high costs of inefficient banking regulation, which has been a recurring problem in the United States.

The Fed's dilemma

The problem for the The Fed is that there are excellent reasons for it to continue raising interest rates and excellent reasons for it to take a break.

On the one hand, the economic data of the last few weeks suggests that inflation is not falling as quickly as analysts expected. Average consumer prices are about 6% higher than a year ago, and forecasters expect that figure to remain above 3% for most of this year. That's more than Fed officials and many families feel comfortable with. For most of the 21st century, inflation has been closer to 2%.

ImageCredit.. .Source: Bureau of Labor Statistics | From the New York Times

An inflation rate that remains close to 4% for an extended period is problematic for several reasons. This reduces purchasing power and gives people reason to expect inflation to remain high for years. They will then demand higher wages from their employers, potentially causing a spiral in which companies raise prices to pay for the raises and inflation drifts even higher. Today's tight labor market, with unemployment near its lowest level since the 1960s, adds to these risks. The economy still looks warmer than sustainable.

This situation explains why Fed officials originally planned to continue raising their interest rate by benchmark at today's meeting, thereby slowing the economy by increasing the cost of homes, cars and other items that people buy with debt. Some Fed officials favored a quarter-point increase, which would be the same as the increase at the Fed meeting last month. Others preferred a half-point increase, in response to recent worrying inflation data.

The banking problems of the past two weeks have clouded these planes. For what? In addition to slowing the economy, higher interest rates lower the value of many financial assets (as these charts explain). Some bank managers have poorly planned these declines in assets, and their balance sheets have suffered. When customers feared that banks would run out of money to return their deposits, a classic bank run ensued. This led to the collapse of Silicon Valley Bank and Signature Bank, and others remain in jeopardy.

If Fed officials continue to raise their benchmark rate, they risk damaging the balance sheets of more banks and causing further bank runs. That's why a half p...