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The Federal Reserve’s long battle against inflation has resulted in a situation policymakers did not exactly anticipate: a fast-spreading banking crisis.

The sudden collapse of three regional banks — including First Republic Bank, which was <a href="https://www.washingtonpost.com/business/2023/05/01/first-republic-bank-seized-jp-morgan/?itid=lk_inline_manual_1" target=_blank>seized by federal regulators</a> and sold to JPMorgan Chase this week — and ongoing turmoil roiling others including PacWest Bancorp and First Horizon, all have roots in the Fed’s move to sharply hike interest rates to tamp down surging inflation. Although there’s<a href="https://www.washingtonpost.com/business/2023/03/17/bank-regulation-svb-collapse/" target=_blank> plenty of blame to go around. </a>

That’s put the Fed in a difficult spot, as it tries to manage dual threats to the economy — inflation and banking stability.

JPMorgan’s acquisition of First Republic revives too-big-to-fail talk

How exactly did we get here? Here, in seven charts, is a look at how the Fed’s fight against high prices helped trigger instability in the banking sector:

The economy all but came to a standstill when covid took hold in March 2020. More than 20 million workers lost their jobs. Schools, restaurants, gyms and countless other businesses shut their doors. Everybody was ordered to stay home.

As a result, the economy plunged into a steep recession.

By the time things opened back up — and people began spending again, armed with new stimulus funds — there were major shortages, supply chain snarls and production hiccups that stoked inflation. Demand for goods skyrocketed, while supply remained depressed. The result: higher prices.

But the Fed didn’t act. Policymakers, including the president, were adamant that the inflation was temporary and would sort itself out once pandemic-related shocks calmed down.

Timeline: U.S. policymakers misjudged inflation threat until it was too late

It wasn’t until December 2021, when inflation hit a 40-year high of 6.8 percent, that Fed officials began talking about raising interest rates. They finally did so — by a modest quarter percentage point — in March 2022. By then, prices had risen a whopping 9 percent from the previous year.

In total, the central bank has raised interest rates ten times, with the goal of slowing the economy enough to curb inflation.

Fed raises rates by 0.25 percentage points in what could be final hike

But a number of new complications — including the war in Ukraine, which led to higher gas and energy costs — forced the Fed to double down on its efforts. Each jump in interest rates dealt a shock to the economy, though it wasn’t immediately clear what the end result would be.

The central bank controls just one interest rate: the federal funds rate, which is what banks use to lend money to each other overnight.

That rate has skyrocketed from near zero to above 5 percent in the past year, the fastest increase on record.

And it doesn’t take long for banks to pass on those higher borrowing costs to customers: Mortgages, business loans and other types of lending have all gotten more expensive in the past year.

Four ways the Fed's interest rate hike could affect you

Bonds, which are loans to a company, or in this case the government, typically pay fixed interest rates and are seen as safe and reliable investments.

And while the Treasury Department always issues a lot of bonds, it has issued even more in the past 10 years, because that’s how the U.S. government finances pricey projects. Trump tax cuts. Pentagon budget. Covid-era stimulus programs to prop up the economy under Trump and Biden.

See how the national debt grew to $31 trillion

But as interest rates climbed, investors were more interested in new bonds that promised to pay more. Long-term bonds tied to older, lower rates, became less desirable — and therefore less valuable.

That caused the bond market to nosedive last year, resulting in its steepest decline ever.

In recent years, banks — newly flush with extra deposits from pandemic-era savings and stimulus — bulked up on bonds and other fixed-rate investments like mortgage-backed securities. At SVB, fixed-rate securities made up nearly 60 percent of the bank’s assets at the end of 2022.

But as the Fed raised interest rates, those bonds became less valuable.<b> </b>SVB’s $91 billion portfolio of long-term securities was worth <a href="https://d18rn0p25nwr6d.cloudfront.net/CIK-0000719739/f36fc4d7-9459-41d7-9e3d-2c468971b386.pdf" target="_blank">just $76 billion</a> at the end of 2022. That $15 billion gap was far wider than the $1 billion shortfall the company reported a year earlier.

In addition, the vast majority of the bank’s deposits — nearly 94 percent — were uninsured, according to data from S&amp;P Global. The national average is about half, which left SVB especially vulnerable to fears of a run that became self-fulfilling. The bank’s customers withdrew $42 billion in just 24 hours, leaving the bank with a negative balance of $1 billion.

“It’s simple: When interest rates go up, the value of bonds go down,” said Darrell Duffie, a management and finance professor at Stanford University. “Silicon Valley Bank had a whole lot of bonds — both treasury securities and mortgage bonds — so when the Fed raised interest rates to try to reduce inflation, the value of all of those bonds went down.”

That wouldn’t have been a big deal if SVB had been able to hold onto its bonds until they matured. But with a rush of depositors clamoring to take their money from the bank, SVB had no choice but to sell its securities at a massive loss. The bank quickly collapsed.

“It was a classic bank run,” Duffie said.

And it helped set off similar runs elsewhere. First Republic also had a lot of long-term investments in securities as well as home mortgages, which lost value in the interest rate run up. First Republic lost $100 billion in deposits following SVB’s downfall, which eventually led to its own demise.

The 72-hour scramble to save the United States from a banking crisis

SVB wasn’t alone in its stockpile of depreciating bonds. U.S. banks are sitting on a staggering $620 billion in unrealized losses, according to the FDIC.

The Federal Reserve in March stepped in with <a href="https://www.washingtonpost.com/us-policy/2023/03/12/silicon-valley-bank-deposits/?itid=ap_jeffstein" target=_blank>an emergency program</a> that allows banks to trade in devalued bonds for their original value in cash. While this offers a temporary fix, economists say there may be other unforeseen issues lurking in the financial sector.

“So far, we’ve been able to prevent big spillover effects — the central bank and others have come in with rapid solutions to keep this from metastasizing into a broader banking crisis,” said Dana Peterson, chief economist at the Conference Board. “But there could still be more shoes to drop.”

The Fed has moved quickly to stem a broader financial crisis, launching a new emergency lending program with generous terms to complement its existing “discount window” for emergency loans. The measures quickly gained traction, with banks<b> </b>borrowing at the window hitting an all-time high of $153 billion.

Borrowing in that program is easing up but remains elevated.

What is the Fed's discount window and why are banks using it so much?

Fears of a broader banking crisis continue to weigh on policymakers and government officials. The whirlwind events of the past two months have raised new questions about the Fed’s long-term <a href="http://strategy.next/" target="_blank">strategy</a>.

While JPMorgan Chase’s Jamie Dimon declared the current financial crisis “over,” earlier this week, financial experts are concerned that the investor sell-off of <a href="https://www.washingtonpost.com/business/2023/05/04/pacwest-bank-stock-drop/" target=_blank>PacWest and First Horizon could trigger a new wave of panic. </a>

The central bank raised interest rates again this week for the 10th straight time, though it has signaled that could hold off on further hikes. The challenge will be figuring out how high to lift interest rates so that it can continue bringing down inflation without wrecking the banking system.

“We will continue to very carefully monitor what’s going on in the banking system, and we’ll factor that assessment into our decisions in an important way going forward,” Fed Chair Jerome H. Powell said in a news conference this week.

Gerald Loeb Award, Beat Reporting, 2021

Northwestern University, Medill School of Journalism

Abha Bhattarai is the economics correspondent for The Washington Post. She previously covered retail for the publication.

Abha Bhattarai

washpost

How the Fed’s inflation fight and higher interest rates triggered turmoil in the banking system

the-washington-post

First Republic Bank branch in New York City

Reuters

Eduardo Munoz

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