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 much better than it could have been.

Two major developments last week bolstered the central bank's credibility in setting monetary as well as bank regulatory policy at a time when it is facing heavy scrutiny on both fronts.

First, a better-than-expected inflation reading from the Bureau of Labor Statistics' consumer price index provided evidence that the Fed's efforts to cool down the economy are taking effect. Prices rose 7.7% year over year, the smallest increase since January. Excluding volatile factors such as food and energy — as the Fed does when setting monetary policy — annual inflation was just 6.3%. 

David Paul Morris/Bloomberg

"The CPI report was certainly welcome news for the Fed, more so if the next month shows that inflation has peaked," said David Wessel, director of the Brookings Institution's Hutchins Center for Fiscal and Monetary Policy. "Not sure how to draw the line between good news and absence of bad. Certainly much more good than bad. And we have had so much bad news and bad luck lately that many people were primed for more."

Last week also saw the sudden collapse of FTX, the world's second-largest cryptocurrency exchange, once valued at $32 billion. Despite its precipitous decline, FTX's demise transpired with minimal apparent impact on broader financial markets, a nod to efforts by the Fed and other bank regulators to minimize the banking system's exposure to crypto, policy advocates say.

Had FTX or its affiliates been granted access to the Fed's payment system, the outcome would have likely been much worse, said Dennis Kelleher, head of the consumer advocacy group Better Markets. 

FTX had not openly sought access to a so-called Fed master account, but other digital-asset firms have, and the Fed's process for handling such applications has been a point of controversy among some legislators. A piece of draft legislation on digital asset regulation from Sens. Cynthia Lummis, R-Wyo., and Kirsten Gillibrand, D-N.Y., would have given any state chartered institution, including those that deal in crypto, automatic access to Fed accounts. 

Kelleher, in a white paper released Sunday, said such access would have led to banks to engage with the crypto industry in a way that would have turned the FTX failure into a "catastrophe." He credited the Fed and other bank regulators for preventing this by withstanding a strong lobbying push by 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 those regulators did not allow those interconnections, which is what happened with subprime in the early 2000s leading directly to the 2008 crash," Kelleher wrote. "No one should misunderstand: the pressure on those regulators was unimaginable, coming from the crypto industry, Wall Street's biggest banks and finance more broadly who were salivating at the prospects of being a quick billionaire like [FTX founder Sam Bankman-Fried], and the hundreds of political allies throughout Washington all purchased with crypto cash."

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FTX did respond to a request for comment. Neither did representatives for Lummis or Gillibrand. 

John Court, executive vice president and general counsel of Bank Policy Institute, also praised regulators for keeping crypto out of the financial system. He said FTX's collapse is proof positive of the risks the emerging industry presents.

"As FTX seeks a bailout, policymakers should ensure they do not embed such firms 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 policy specialists are quick to note that the events of last week are not fully vindicating for the Fed, which has been criticized for its handling of inflation — first by reacting too slowly to it, then, more recently, by combating it to aggressively — and faces significant challenges to its independence and discretion in granting master accounts.

"It could have been a very bad week, but the fact that there weren't crises is a pretty faint measure of success," said Karen Petrou, managing partner of Federal Financial Analytics.

The positives 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 is not clear how much credit for slowing inflation belongs to the Fed's rate hikes. He points out that the CPI's month-to-month increase of 0.4% in October was the same as September, but with different driving factors. 

"Things are uneven in terms of trends," Michel said, "and it's hard to reconcile rate hikes themselves being responsible for those particular changes."

Wessel said the largely positive reactions of stock and bond markets to last week's inflation reading could undermine the Fed's effort to temper the economy, if participants begin assuming an easing of monetary policy is imminent. 

With the worst effects of tighter monetary policy yet to come, Wessel expects the Fed to see more scrutiny before being praised.

"The Fed is not out of the woods yet," he said. "Inflation, while perhaps peaking, remains well above its target. I expect a recession next year and that will intensify political attacks on the Fed from both parties."

Also, while limiting the banking sector's exposure to crypto has insulated the Federal Reserve System from the worst of the FTX collapse, Wessel said it was too soon to say the ongoing crypto crisis will be entirely self-contained. He noted that then-Treasury Secretary Henry Paulson and Fed Chair Ben Bernanke felt that way in the early days of the subprime mortgage crisis in 2007 and 2008 before it upended financial markets globally.

Komal Sri-Kumar, a senior fellow at the Milken Institute and an independent macroeconomic consultant, said FTX and other digital asset firms might be fully insulated from the broader economy, but, inevitably, the Fed's rapid tightening of monetary policy will have broader consequences. How the Fed responds then will be its true measure of success, he said.

"The past week was neither a good nor a bad week," Sri-Kumar said. "It is just a way station in a long march. Put another way, this is the 5-mile mark in a 26.2-mile marathon."