There are two lines of thinking when it comes to how the Fed should approach recent developments in the US banking sector in the context of the inflation fight.

I should quickly note that there are actually many lines of thinking (which, in turn, “inform” many lines of argumentation) but frankly, anyone who’s spending a lot of time immersed in combative social media exchanges or, relatedly, conflating Op-Eds published by the financial media with actual news, is wasting valuable time.

The cacophony of opinions is mostly irrelevant, and it’s not conducive to rational decision making. Social media portals and mainstream news outlets have to pay the bills too, and the way they do that is by monetizing your engagement, which, unfortunately, means maximizing your level of perturbation, not with market developments, but with opinions about those developments. That’s poison. Which is why I don’t do it here.

Instead of getting lost in what, ultimately, is just a political debate, consider two very different, but both very rational, market-based suggestions for what the proper course of monetary policy should be going forward.

One suggests the underlying deposit outflow dynamics need to be addressed, otherwise that problem is going to persist, and could become even more pernicious going forward, notwithstanding any relief rally for the beaten-down equity in some of the affected banks, which’ll probably become meme stocks, if they haven’t already.

Another says that because the friction between i) the kind of policy settings necessary to combat generationally high inflation and ii) the legacy of the post-GFC accommodation era, was the root cause of last week’s bank failures, inflation needs to be extinguished posthaste, otherwise we’re just delaying the inevitable.

In a Tuesday note, Nomura’s Charlie McElligott detailed each of those suggestions, which he described as emanating from client feedback. To wit:

1. One part of the client universe says that in order to kill off the “structural” bleed, the Fed has to either 1) cut rates to break the larger, “bank deposit flight” story to money market funds, as Sunday’s actions cannot stem the confidence being lost in non-SIFIs [especially] with the stocks getting bombed out and no justification for keeping cash there versus the Megas, especially when MMF is 5% versus deposit rates at 0.0%, and/or 2) they have to take steps to begin unwinding the RRP facility, which is also competing for deposits, but was built for an antiquated era with no inflation / no anticipation of this type of shock-tightening environment.
2. Alternatively, the Fed has to remember that the cause of all of this remains inflation.  So, the fix is staying the course on tightening and staying focused on bringing us back to target — finishing the hiking job and getting to / holding appropriately restrictive levels. Because they are close to the disinflationary turn, and not taking additional actions (or cutting rates) would further embed inflation into expectations (i.e., the premature FCI easing in Q4 which allowed for the “hot” January 2023 data), and which perversely sowed the seeds that led us down this path in the first place (ZIRP, large scale asset purchases / QE / speculative-excess and asset valuations, SIVB / VC / Tech bros). To break inflation, some other stuff is going to have to break as well.

Charlie’s own take is that a pause at next week’s FOMC meeting might make sense if it’s paired with an explicit nod to a willingness (I’d suggest telegraphing an inclination) to resume hikes contingent on banking sector stability.

As he put it, describing a “middle ground option” for the Fed, “‘Pause’ next week, in light of the financial stability issue and while you evaluate the data, but simultaneously message [a] tilt towards a willingness to resume tightening / re-start hiking.”

I want to emphasize two things.

First, it’s very difficult to imagine that small and regional banks will be enthusiastic lenders going forward. We can debate whether last week’s events did or didn’t constitute a “systemic risk,” but I think it’s fair to assess that quite a few local institutions were — how should I put this? — less than enamored with the situation. They will absolutely take recent events into consideration when they evaluate loans over the next few months.

Second, if the Fed is going to pause and then restart, I think the restart needs to be in May — so, at the very next meeting. If they wait until June, the delay opens the door to all kinds of two-sided risk. For example, financial conditions could ease to the detriment of the inflation fight and any drop in rates could turbocharge the spring home-buying season but, at the same time, reluctance to lend could proliferate in the banking sector, thereby making a recession a foregone conclusion. And so on. All of that would be hard to “net out” (if you will) for the purposes of the June SEP.