(Bloomberg) - Former Treasury Secretary Lawrence Summers said the Federal Reserve shouldn’t be spooked into easing its campaign to contain inflation out of excessive concern about a credit crunch in the wake of the recent banking turmoil.
“It would be very unfortunate if, out of solicitude for the banking system, the Fed were to slow down its rate of interest-rate increase beyond what was appropriate given the credit contraction,” Summers said on Bloomberg Television’s “Wall Street Week” with David Westin.
Fed policymakers, who meet March 21-22 to set rates, will need to recognize that slower credit creation will result from the tumult triggered by the collapse of two banks last weekend, according to Summers. But “the slowing of credit is not nearly as much” as the amount of Fed tightening that has now been removed from market pricing, he said.
“I do think that the Fed should not allow financial dominance,” said Summers, a Harvard University professor and paid contributor to Bloomberg Television. Financial dominance is a condition where a central bank doesn’t dare to tighten its policy stance as that would threaten the stability of the financial system.
“It’s appropriate — at least on current facts, and they’re changing very quickly these days, but on current facts — to raise rates by 25 basis points” next week, Summers said.
Reacting too strongly to the banking situation by altering interest-rate policy could make many observers “feel that if the Fed was scared, they should be as well” — worsening the situation, Summers said. Easing off on the fight to contain the cost-of-living surge could also lead to higher inflation expectations, he said.
“So ironically, it could both raise inflation expectations and contract the economy,” he said. “I hope the Fed can move forward 25 basis points.”
Summers reiterated his praise for the 50 basis-point rate increase by the European Central Bank on Thursday, and hoped that ECB President Christine Lagarde’s example will be a “role model” for the Fed.
“She made very clear that, with two different problems — inflation and financial stability — you can use two different instruments to respond to those of problems, and not sacrifice on the inflation dimension,” Summers said.
The Fed on Sunday moved to address financial-stability concerns by setting up a new facility to help banks get long-term funding in exchange for assets including Treasuries. The aim is to stem an outflow of deposits from smaller banks.
“We can use policy directed at standing behind depositors separately from monetary policy,” Summers said.
The former Treasury chief also cautioned US regulators from moving too strongly against regional banks, in the aftermath of the problems at Silicon Valley Bank that caused its collapse earlier this month. “Throwing the book” at all regional banks “may exacerbate a credit crunch that we don’t want to have for the longer term,” he said.
Summers indicated that some reform of how deposits are considered may be in order. A key vulnerability for SVB was its reliance on uninsured corporate deposits, which quickly got pulled as the bank’s woes emerged.
The likes of a $5 million start-up firm ought not to have to be in the position of evaluating the creditworthiness of the bank where it parks its payroll cash, according to Summers.
“I hope we move to — over time — a financial system in which basic cash deposits sit in Treasury bills, or sit in institutions that intermediate them into Treasury bills,” he said. “It’s going to take a huge amount of thought, but there are very profound conceptual questions raised here.”
(Updates with comments on regulation and deposits in final four paragraphs.)
By Christopher Anstey