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Opinion Surprised by interest rate hikes? Really?

Jerome H. Powell, chair of the Federal Reserve, speaks during a news conference in D.C. on Wednesday. (Al Drago/Bloomberg News)
5 min

Sometimes in the midst of a crisis it is helpful to go back to basics and ask the most fundamental and obvious question. Like: How the heck is a simple increase in interest rates causing so much chaos in the banking system?

This is an apt time to ask that question because the Fed just raised interest rates again, despite the risk of further convulsions. The choice between stabilizing banks and stabilizing the inflation rate must have been agonizing.

But why is this such a surprising trade-off? Interest rates still aren’t actually that high by historical standards — banks, and the economy, did just fine in the late 1990s when the Fed funds rate was significantly higher. Of course, bumping along at a steady, high rate is quite different from suddenly zooming up to that rate from basically zero over the course of a few months — as homeowners and home buyers have recently discovered. But it’s not as if increasing interest rates was some wild happenstance. Interest rates were effectively zero during the worst months of the pandemic, and there was only one direction they could go after that.

Banks are supposed to have risk managers who protect them against likely happenings; they are not supposed to be standing around saying, “Goshdarnit, the sun rose this morning, and that means now we’re insolvent!” Yet here we are, experiencing a crisis of the conspicuously clear, a predicament of the perfectly predictable.

For it was not just the fools at Silicon Valley Bank who underestimated the danger; Bloomberg reports that it took until late last year for bank regulators to realize that SVB, uh, “needed to improve how it tracked interest-rate risks.” Which is arguably symptomatic of a broader problem: “To me,” tweeted finance professor Will Diamond of the University of Pennsylvania’s Wharton School, “the biggest culprit in SVB’s failure is that the fed’s most severe stress test scenario in 2022 didn’t even consider the possibility of rising interest rates.”

“Asleep at the wheel,” he concluded, and it’s hard to disagree; accountants and economists have been talking about bank interest rate risk for ages. Yet, somehow, SVB was allowed to bet big that rates wouldn’t go up too fast, or too soon. The resulting meltdown triggered further blinding flashes of the obvious — a sort of strobe light of self-evident epiphanies, if you will. Bank customers were surprised that the Federal Deposit Insurance Corporation’s deposit insurance covered only the first $250,000 in their accounts? Really?

To restate the question: What the heck?

Herd mentality offers an explanation. It’s not entirely irrational to think that if everyone else is doing something, it must be a good idea. Moreover, the herd’s behavior can shape reality: If everyone thinks Tesla is worth a zillion dollars a share, it will be. And if everyone thinks a bank is insolvent, that bank will fail, no matter how well capitalized or soundly regulated it is.

Over the long term, markets do eventually discover, and correct, mistakes. But in the short term, the herd can run in the wrong direction for a long time. As the old Wall Street saw goes, the market can stay irrational longer than you can stay solvent. I once met a fellow who made a killing shorting the Nasdaq in 2000 — but he had started shorting it in 1997 and very nearly went bankrupt before his bet finally paid off.

Also, herding makes sense when the downsides to getting it wrong individually are greater than getting it wrong in a group — if one money manager takes a bath on dodgy mortgage bonds, he’s unemployed, but if the entire financial sector does, hello, bailout. This blunts the incentive to bet against an irrational market.

These difficulties are compounded by recency bias: The longer something has gone on, the harder it is to believe that it will stop. I’m sure we can all remember our own disbelief that modern people like us could be experiencing anything as primitive as a deadly pandemic. So, too, in markets: The longer the herd runs, the more recency bias tells you that it is likely to run forever.

This doesn’t just affect risk-loving traders; we are repeatedly disappointed to discover that regulators failed to forestall a crisis, because they made the same dumb assumptions as the people they were regulating. In the years leading up to the housing crisis, it was common to hear economists discussing “the great moderation” — a notable decline in macroeconomic volatility that started in the 1980s — suggesting that regulators had gotten so good at their jobs that another Great Depression was practically impossible. This was essentially the same mistake that people in credit markets were making when they said that everything was fine, really, because we hadn’t had a nationwide decrease in house prices since the Great Depression. Both were treating “not since the Great Depression” as a synonym for “impossible.”

The upshot of these tendencies is that even small, seemingly innocuous changes, such as a modest increase in interest rates, can trigger major changes in herd behavior because they alert the herd to some danger that was there all along. And as the herd careens off in some disastrous new direction, often all that regulators can do is try to stay just far enough ahead of the stampede to keep it from running us all over the cliff.