Jerome Powell on the Horns of Dilemma of the Federal Reserve's Own Making

• Chairman Jerome Powell will announce the Federal Reserve's decision on interest rates this week amid a banking crisis and sky-high inflation.
• Experts say these problems were both fueled by the Fed, where Powell has been at the helm since 2018.
• There are concerns an interest rate hike would put more pressure on the banking industry just days after the collapse of Silicon Valley Bank.
• But without a rate rise, there are fears inflation will run rampant and make food and housing even more expensive for Americans.

The road to hell, the proverb goes, is paved with good intentions. And through Jerome H. Powell's stewardship of the Federal Reserve, it would appear America could soon arrive at that destination.

In trying to help everyone from bankers to regular Americans, Powell has landed the country in an economic quagmire of his and the Fed's own making, experts have told Newsweek.

While a global pandemic and the war in Ukraine have been massive shocks to the economic system, the decisions of the Federal Reserve, where Powell has been chairman since 2018, have played their part, observers say.

"We have a fragile system, there is no doubt," Thomas Hoenig, who served as vice chairman of the Federal Deposit Insurance Corporation from 2012 until 2018, told Newsweek. "It's been over a decade of low interest rates. That is part of the problem. It is self-caused."

The Federal Reserve did not comment because of its usual media blackout ahead of this week's Federal Open Market Committee (FOMC) meeting.

A critic of the hyper-expansionist balance sheet when he joined the FOMC in 2012, during COVID Powell fired off a financial bazooka that far outgunned the quantitative easing the Fed unleashed during the banking crisis and the years that followed. This swelled the Fed's balance sheet from $4.5 trillion in 2015 to more than $8 trillion by the end of 2020.

Powell pumped trillions into the financial system in a bid to bolster the nation's economy during the pandemic, despite warnings prices would rise as a result. He kept the money tap open long into 2021, fanning the flames of inflation that bedevil Americans today.

On Sunday night, in a fresh action to calm fears of further banking chaos, the Federal Reserve announced a joint plan with the Banks of England, Canada and Japan, the European Central Bank and the Swiss National Bank, to improve U.S. dollar liquidity, pouring yet more money into the system.

At the first hint of price rises, in June 2021, Powell labeled inflation "transitory." It wasn't until March 2022 that Powell declared an inflation emergency and started jacking up rates in a bid to bring it down. Yet by the Fed's November meeting he predicted "smaller" increases going forward as the inflation dragon was being tamed, before sounding the alarm again in February.

Americans, meanwhile, have been saddled with a cost-of-living crisis coupled with a banking crisis, as well as the threat of recession and an erratic housing market.

The Fed has put up interest rates from .25 percent in February 2022 to 4.5-4.75 percent today—and they could jump even higher if Powell persists with his war on inflation this week.

Yet these short, sharp rate increases, coupled with the loosening of banking legislation in 2018 that Powell ran with, sowed the seeds of the collapse of Silicon Valley Bank (SVB) and Signature Bank earlier this month.

Now Powell finds himself on the horns of a dilemma: spare the economy a banking crisis he should have foreseen or press ahead with a rate rise to protect ordinary Americans from the ravages of high inflation he helped fuel and preserve the Fed's credibility.

"It shows the extreme difficulty central banks have everywhere as low interest rates have been embedded in the structure. When interest rates rise, you are going to have these explosions," financial historian Edward Chancellor, author of The Price of Time: The Real Story of Interest, told Newsweek, referring to the banks' demise. "You can't really get out of this trap. Every time [rates go up] you get one of these blow ups."

'Get Inflation Back Down'

While Powell may have been lambasted by Elizabeth Warren last week for "directly contributing to these bank failures," with the upcoming interest rate decision he and the FOMC will also have to address two of the Fed's core responsibilities: price stability and the 2 percent inflation rate target.

"The first priority has to be to get inflation back down," said Hoenig, now a Distinguished Senior Fellow at the Mercatus Center at George Mason University. "That may cause unemployment to go up. But if they [the Fed] don't get it under control now, it will go up a lot later. They need to stay the course."

"The risk is if you back off too soon, inflation will rise a little bit more and you have a bigger problem down the road," he added. "This brings you back to the 70s."

At the end of that decade, inflation topped 11 percent with interest rates close to 20 percent.

Hoenig described inflation as a "pernicious tax" on people's lives, and for many Americans it feels that way. The cost of everyday essentials is still soaring. Overall, the consumer price index is at 6 percent, but rent is up 8.8 percent, food at home is 10.2 per cent higher and electricity inflation stands at 12.9 percent.

The effect on everyday Americans is plain to see. In a February report shared with Newsweek, charity Feeding America said around 75 percent of responding food banks saw demand for food assistance increase or stay the same in January 2023 compared with December 2022. A January survey revealed 95 percent of food banks polled said inflationary pressure on family budgets was the main reason for people seeking assistance.

While high inflation means retirees and those on fixed incomes will be feeling the pinch, younger Americans are suffering too, says Taylor Price, a Gen Z money expert who has 1.1 million followers on TikTok.

"High inflation is impacting on younger people's lives," she told Newsweek. "The cost of living is extremely expensive. And for young people who are just starting to save for retirement, they might find that their savings now might actually be worth less over time due to inflation. It's essentially eroding their savings."

'Double-Edged Sword'

But the threat of higher interest rates isn't that appealing either for people having to take out student loans, or looking to buy a car or get on the property ladder. Higher rates make borrowing more expensive and, as Hoenig said, an increase will likely mean more unemployment, with younger workers at greatest risk.

"It's definitely a double-edged sword," Price said. "I think a lot of people are now looking back at the mortgage rates and saying, 'Wow, look at how low the rates were a few years ago.' Now the roof is a lot higher, and they're taking a look at their living situation now, and saying, 'Maybe that was the time to get in.' So it's a lot of looking back at, oh, I wish I could have done something and made a decision then versus now, where it's a lot harder."

The housing market may have fallen into recession as interest rates have risen, but affordability is still an issue, Matthew Walsh, an economist with Moody's Analytics, told Newsweek. In a report dated February 24, he wrote: "The U.S. housing market is crumbling under the weight of higher mortgage rates and rock-bottom affordability."

Big price declines have only affected the top tier of the market, he said, with the cost of first-time buys in particular remaining "sticky." Walsh added: "Not only do you have high competition for those properties, there are fewer of them."

"A small decline [in inflation] would not be enough to ease the affordability problem," he warned. "If inflation continues to rise, it will take a significant bite out of household budgets and it will take a Herculean effort to buy a house. It is making it even more difficult for first-time buyers."

The last line of Walsh's report also underscores how Powell's Fed has failed to maintain price stability: "Two years of record appreciation caused housing wealth to soar by $11 trillion. By 2025, house prices will be back to their late-2021 level, eliminating an estimated $4 trillion in housing wealth."

'There's Been a Loss of Financial Discipline'

The case, then, for an interest rate rise remains strong. But despite protections put in place for depositors, the banking system remains fragile, especially for small and mid-sized banks. Then there is the risk of contagion from foreign lenders as well.

The failures of SVB and Signature Bank have led to cries of outrage from financiers. Hedge fund billionaire Bill Ackman wrote on Twitter: "Our economy will not function effectively without our community and regional banking system."

Yet the move to rescue depositors has also been condemned. Ken Griffin, founder of hedge fund Citadel, told the Financial Times on March 13: "The U.S. is supposed to be a capitalist economy, and that's breaking down before our eyes... there's been a loss of financial discipline with the government bailing out depositors in full."

He added: "It would have been a great lesson in moral hazard... it would have driven home the point that risk management is essential."

Plunging bond prices have left the U.S. banking system's market value of assets $2 trillion lower than suggested by their book value. Banks in the U.S., Japan and Europe have collectively lost $459 billion in market value this month, as of Friday. However, fears another rise will increase the squeeze on long-dated Treasuries had been abated somewhat last week, thanks to the Bank Term Funding Program, which led some people to think rates would be going up.

"There is a risk either way," Hoenig, who led the Federal Reserve Bank of Kansas City during the banking crisis of 2008 and 2009, said on Thursday. "I think they'll go for 25 [basis points] and then pause.

"Everyone understands why they wouldn't go forward. People are nervous. Inflation is high but did come down a little last month. The other side of the issue, if you pause now the market will expect you to continue reducing rates… They should stay the course and get inflation down."

DoubleLine Capital CEO Jeffrey Gundlach concurred in an interview last week with CNBC, although he warned the Fed against it.

"I just think to save... their credibility, they'll probably raise rates 25 basis points. I would think that that would be the last increase," Gundlach said.

Chancellor is not so hopeful. "You'll get inflation for the next decade or so, which will erode the debt," he said last Thursday, referring to the trillions in devalued Treasury bonds being held by banks around the world. Sunday night's action by the Fed and other central banks to further increase U.S. dollar liquidity could well prove Chancellor right.

Chancellor says the root cause of Powell's dilemma is that the Fed kept interest rates at historical lows for too long, which inflated asset prices to create what the author called an "everything bubble." This, he said, has left America at risk of more financial tremors.

"Jay Powell a week ago was saying he was going to tighten, and then within four days you have a banking crisis," Chancellor added. "The Fed is now guaranteeing the balance sheets of the entire banking system. Very low rates entered into all the cracks of the financial system... you don't know where they are all going to emerge."