A Discussion about SVB: Inflation and Preparation
Over the weekend you may have heard about the Silicon Valley Bank crisis. I won’t get too deeply into the details, but the short version is the bank ran into a liquidity crisis, meaning it was essentially cash poor, and when its depositors got wind of that there was a run on the bank. This prompted the bank’s takeover by the FDIC and eventually, as of right about now when I’m writing this, a bailout of the depositors by the US Treasury. What I do want to talk about is one of the drivers behind the crisis at SVB, which is the Fed and inflation. SVB’s liquidity crisis was driven largely by the fact that they held a number of assets that held significant interest rate risks, meaning higher interest rates would cause the value of those assets to go down. So SVB’s balance sheet was directly and heavily impacted by the Fed raising rates over the last year.
Coincidentally, this week some of my MBA classmates were discussing this video of Jerome Powell (the Fed chairman) testifying on the hill about the Fed’s actions in combating inflation, which, since the Fed only has so many available tools, are mainly to raise interest rates. A quick summary: Senator Elizabeth Warren was questioning him, and she clearly does not necessarily agree with this course of action. Warren starts her questioning by stating that she believes the actual drivers of inflation are not impacted heavily by the Fed’s blunt instrument, and goes on to insinuate that by continuing to use interest rates Powell will, in her assessment needlessly, drive up unemployment.
I heard two chief complaints about her questioning. The first was about the manner of the questioning, particularly that she preemptively hung two million lost jobs on Powell. This complaint feels to me like complaining that a defense counsel in court was too vigorous in his closing argument. Warren disagrees with Powell and is going to try to make her case as pointedly as possible. This should be expected. But the second complaint is more interesting. That complaint is that Warren should not attack Powell so harshly because he is taking necessary action, and some confluence of actions by lawmakers like Warren tied his hands and forced him to risk unemployment and indeed recession in the name of curbing inflation. So, Warren disagrees with the Fed action, and others in the business and econ communities, including some of my esteemed classmates, think Fed rate raises are a required course of action. Who is right? As usual, the answer is complicated.
At a high level, there are two stories about inflation. Senator Warren’s story is more or less about supply-side inflation, meaning constrictions in supply drove higher prices. Powell’s story, at least by behavior, is more about demand-side inflation, meaning that some influx of money to consumers drove demand higher than usual, and drove increases in prices. Rather than look at the technical charts and jargon that explain these phenomena, I think it’s best to explain by example.
Supply-side inflation: In late 2021 and early 2022 you may recall that used car prices were very high. That means that the used car market was experiencing some serious inflation, which is coming to an end. The story of used car inflation is a supply-side story. At the time, new car manufacturers were struggling to make cars. Part of the reason for this was that computer chip manufacturers in Taiwan and other places were unable to make enough computer chips for these car manufacturers to put in their cars. With car manufacturers unable to meet the demand for new cars, car dealerships that, in normal circumstances, would have brought new cars on the lot found themselves needing to get any cars at all on their lots, which means that those dealers started buying used cars in higher volume than usual and driving up prices on those used cars. Without the supply constraint on new cars, used car prices likely would not have risen as much.
Demand-side inflation: This story is a bit simpler, though don’t mistake that for “more likely” or “more important”. While business activity was shut down during the pandemic, people were saving their money because they were no longer going to the movies or restaurants or taking trips to Disney World. They were also getting influxes of cash from the US government. The government was concerned about saving people from pandemic unemployment and about staving off a massive loss of businesses due to pandemic pressures, and to stop the worst from happening they just decided to give people and businesses a ton of money. Once the constraints on businesses were lifted, consumers had more money on hand than usual to spend, and spend it they did. This money was deeper and lasted longer than many anticipated, and this sustained increase in demand drove up prices for scarce goods and services.
The reality is that the extreme inflation that was playing out, particularly mid-year last year, is some mix of both of these. Most experts would agree with that, the only quibble is about which one is most prominent overall, and more importantly right now.
Fed rate increases primarily impact demand-side problems. When the Fed increases rates, it makes it more expensive for consumers and businesses to borrow money, and in turn makes them spend less. However, a second order effect of rate increases can also impact supply-side inflation by tempering demand to meet current supply or create conditions of oversupply where suppliers are incentivized to drop prices. All of this together represents an overall slowdown in economic activity, which almost always creates conditions for increased unemployment and potentially recession. Importantly, it is very hard for the Fed to gauge just how much interest rate pressure to use, and it is very easy for the Fed to go “too far” and deeply gouge the economy. This is Warren’s gripe with rate increases, she thinks inflation will be solved, eventually, by using government policy and good old innovation to stop what she deems as price gouging, iron out supply chain kinks, and create new sources of supply to meet demand without the need for the Fed to use its tools so aggressively.
I think Warren has a case, though I think her case was much flimsier four months ago. First, let's look at what is happening with inflation. Below is a chart of the 12-month inflation rate by month. What that means is the inflation rate recorded in December 2022 is the inflation that occurred from January 2022 to December of 2022. Similarly the inflation recorded in January 2023 is the inflation that occurred from February 2022 to January 2023. The reason they use a 12-month average is to smooth out the idiosyncratic price movements that happen month-to-month. Nobody expects ice cream demand to be the same in January as it is in July, there are demand and price changes that happen simply due to the way we change our spending throughout the year. A 12-month average controls for those idiosyncrasies.
So we can see that while inflation is on a downward trend, it’s far higher than what we saw in January 2020 (which is probably the last “normal” month we have in this chart). An optimistic read of this chart would be that the momentum is in the right direction, and we can just let inflation take its current course. Powell disagrees, and that’s why he’s indicating that the Fed is going to continue aggressively combating inflation with interest rates.
Why does Powell think this is the case? To illustrate one reason, below is a chart of the personal savings rate in the US since 2019.
The savings rate from May 2020 til about March 2021 was exceedingly high, and our savings rate now is below what we saw pre-pandemic. This means that Americans stowed a ton of money away during the pandemic years and all that money was/is just sitting waiting to be spent. Additionally, since savings rates are lower now than pre-pandemic, it could mean we’re spending at sustained increased rates independent of the built up pandemic savings. All of this keeps demand pressure high, so in Powell’s mind, it’s best to continue making it more expensive to invest and, in turn, hopefully turn off the demand spigot driven by our massive savings from 2020 and 2021.
There are other factors. Wage growth is slowing, which indicates we’re unlikely to experience a wage-price spiral. Jobs continue to be created which means more people are earning money which could increase demand, but unemployment rose in the last set of unemployment data, which means even though the number of jobs increased, the number of people looking for jobs increased more than the number of jobs. There are tons of data points we can look at to develop a narrative about inflation, and most of the people with popular platforms are less invested in getting the story right and more invested in baking it into whatever overarching narrative they are trying to pitch. All of this is to say it matters less why inflation is happening and more what is going to happen due to inflation.
Personally, I think our last few months of inflation data indicate that the Fed should at least seriously reconsider whether they are going to continue with this path of rate hikes. In my opinion there’s a clear case for a “soft landing” where inflation comes under control without putting tons of pressure on employment and without driving the economy into recession. Before about September 2022, as seen in the inflation chart, it was fairly difficult to make the case that inflation would meaningfully turn without Fed action, but after that point the argument that it’s possible the Fed has gone far enough is becoming more and more sound with each month of data.
However, and I may have buried the lede here, it does not matter what I think, or what Senator Warren thinks, what matters is what Jerome Powell thinks. And when he was interviewed ahead of the last Fed board meeting, he indicated that he was unconvinced by the optimistic inflation data. This week he doubled down saying that the inflation data was hotter than expected in Jan and Feb and that Fed rate increase might be higher than initially indicated.
The Business Case
So what of SVB? If SVB did an analysis of what the future of inflation would hold for them, like the quick one I did above, there’s little evidence of it (or at least little evidence that they did anything about it). Certain narratives have started to form around its failure, from the self-serving VC narrative that SVB was a victim of circumstance and should get big bank bailout treatment with no questions asked, to the laughable narrative being peddled by certain right wing media that SVBs failure was due to “wokeism”. The actual reason SVB failed is far more boring. They were ignoring systemic risks, they were resting on their laurels, and they never thought that the conditions they were operating in were subject to change. Even after there was evidence that the sands were shifting under their feet, they moved slowly. Interest rate risk is not some arcane concept for a bank, it is arguably the biggest risk to most individual bank assets. For the bank’s portfolio of investments, the core risk is concentration. SVB never hedged either risk, they remained highly concentrated in tech startups and invested in assets that would be tough to sell if interest rates rose. SVB put some of what I’d call their “safe” bets into slightly less safe bets in order to make a bit more profit. They thought they would have a steady inflow of cash from startup investments and that they could hold their interest bearing assets long term without considering liquidating them, and thus slightly hedging their interest rate risks. The cash stopped flowing, they needed more cash to steady their ship, and they didn’t have anything worthwhile to sell. SVB could have easily seen and hedged their Jerome-Powell-related risks, they could see them just as easily as we outlined above, but they chose to act like yesterday would be the same as today which would be the same as tomorrow. Complacency brings the death knells.