For the Fed, less bad news is good news

WASHINGTON — After a year of scrutiny and criticism, the Federal Reserve had a good week — or at least a week that was way better than it could have been.

Two key developments over the past week have bolstered the central bank’s credibility in setting monetary and banking regulatory policies at a time when it faces severe scrutiny on both fronts.

First one better than expected inflation figures from the Bureau of Labor Statistics Consumer Price Index showed that the Fed’s efforts to cool the economy are having an effect. Prices rose 7.7% year over year, the smallest increase since January. Excluding volatile factors like food and energy — like the Fed does when setting monetary policy — annual inflation was just 6.3%.

Powell Brainard Williams
Federal Reserve Bank of New York President John Williams, left, Federal Reserve Vice Chairman Lael Brainard and Chairman Jerome Powell made two major gains last week, with inflation appearing to be halted and the collapse of the FTX crypto exchange remained relatively contained.

David Paul Morris/Bloomberg

“The CPI report was certainly welcome news for the Fed, even more so if next month shows inflation has peaked,” said David Wessel, director of the Brookings Institution’s Hutchins Center for Fiscal and Monetary Policy. “I’m not sure how to draw the line between good news and the absence of bad. Certainly a lot more good than bad. And we’ve had so much bad news and bad luck lately that a lot of people were prepared for more.”

Last week also saw the sudden collapse of FTX, the second largest cryptocurrency exchange in the world, which was once worth $32 billion. Despite its precipitous decline, FTX’s decline proceeded with minimal apparent impact on broader financial markets, a nod to efforts by the Fed and other banking regulators to minimize the banking system’s exposure to crypto, political proponents say.

Had FTX or its affiliates granted access to the Fed’s payments system, the outcome likely would have been far worse, said Dennis Kelleher, head of consumer protection group Better Markets.

FTX had not openly sought access to a so-called Fed master account, but other digital asset companies have done so and the Fed’s process for processing such requests was a point of contention under some lawmakers. A digital asset regulation bill by Sens. Cynthia Lummis, R-Wyo., and Kirsten Gillibrand, DN.Y., would have granted automatic access to Fed accounts to any federally-licensed entity, including those trading crypto.

Kelleher said in a white paper published Sunday such access would have led to banks engaging with the crypto industry in a way that would have turned FTX’s failure into a “disaster.” He credited the Fed and other banking regulators with preventing this by withstanding a strong lobbying push from the crypto industry and its allies.

“The only reason the ongoing crypto carnage hasn’t turned into a financial crisis, crash and bailouts is because these regulators didn’t allow for these connections, which happened with subprime in the early 2000s and directly led to the crash of 2008,” Kelleher wrote. “No one should misunderstand: the pressure on these regulators has been unimaginable and has come from the crypto industry, Wall Street’s biggest banks and finance at large, salivating at the prospect of becoming a quick billionaire [FTX founder Sam Bankman-Fried]and the hundreds of political allies across Washington, all bought with cryptocurrency.

FTX has responded to a request for comment. Neither did representatives of Lummis or Gillibrand.

Bank Policy Institute Executive Vice President and General Counsel John Court also commended regulators for keeping crypto out of the financial system. He said FTX’s collapse was positive evidence of the risks presented by the emerging industry.

“As FTX seeks a bailout, policymakers should ensure they don’t embed such companies in the heart of the financial system by giving them Fed accounts,” he said, “otherwise the next crisis in the cryptoverse could threaten financial stability.”

Economists and policymakers are quick to note that the events of the past week don’t fully justify what the Fed has done been criticized for its handling of inflation – first by reacting too slowly to it, then more recently by fighting it too aggressively – and faces significant challenges to its independence and discretion in granting principal accounts.

“It could have been a very bad week, but the fact that there were no crises is a pretty poor gauge of success,” said Karen Petrou, managing partner of Federal Financial Analytics.

The positive results of last week’s episodes also come with significant caveats.

Norbert Michel, director of the Cato Institute’s Center for Monetary and Financial Alternatives, said it’s not clear how much credit the Fed’s rate hikes should have for slowing inflation. He points out that the monthly CPI increase of 0.4% in October was the same as in September, but with different driving factors.

“Things are mixed in terms of trends,” Michel said, “and it’s hard to reconcile rate hikes themselves, which are responsible for these particular changes.”

Wessel said the broadly positive reaction from stock and bond markets to last week’s inflation readings could undermine the Fed’s efforts to dampen the economy if participants believe monetary easing is imminent.

With the worst ramifications of tighter monetary policy still to come, Wessel expects the Fed to come under closer scrutiny before praising it.

“The Fed is not out of the woods yet,” he said. “Inflation may peak, but remains well above target. I expect a recession next year and that will increase political attacks on the Fed from both parties.”

While limiting the banking sector’s exposure to crypto has protected the Federal Reserve System from the worst of the FTX collapse, Wessel said it’s too early to say the ongoing crypto crisis will be fully self-contained. He noted that this is what then-Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke thought in the early days of the subprime mortgage crisis in 2007 and 2008, before it turned financial markets around the world upside down.

Komal Sri-Kumar, a senior fellow at the Milken Institute and an independent macroeconomic advisor, said FTX and other digital asset firms may be completely isolated from the broader economy, but the Fed’s rapid monetary tightening will inevitably have wider implications. How the Fed then responds will be its true measure of success, he said.

“The past week was neither a good nor a bad week,” said Sri-Kumar. “It’s just a stopover on a long march. In other words, this is the 5-mile mark in a 26.2-mile marathon.”

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