Coping with Inflation Interest and Banking Woes: How to Keep Your Finances on Track
Interest
The recent collapse of Silicon Valley Bank and several other financial institutions has sparked a wave of panic and uncertainty among depositors and investors.
Many are wondering if their money is safe in the banks or if they should withdraw it and look for alternative ways to store their wealth.
At the same time, the Federal Reserve has raised its interest rate for the fifth time in a year, signaling its determination to combat inflation that has soared to over 6% annually.
How do these two developments affect your money and what should you do to protect it?
Understanding Interest Rates
First of all, it is important to understand the difference between nominal and real interest rates.
Nominal interest rate is the rate that you see advertised by banks or other lenders, such as 4% or 5%.
Real interest rate is the nominal interest rate minus inflation, which reflects the actual purchasing power of your money over time.
For example, if the nominal interest rate is 4% and inflation is 6%, then the real interest rate is -2%, meaning that your money loses value yearly.
The Fed’s main goal is to keep inflation low and stable, around 2%, which is considered optimal for economic growth and stability.
When inflation rises above this target, the Fed raises its interest rate to make borrowing more expensive and reduce demand for goods and services.
This slows down the economy and puts downward pressure on prices.
However, this also means that savers and investors earn higher returns on their deposits and bonds, which can offset some of the losses from inflation.
Interest Rates Are Key
The problem is that higher interest rates also have negative consequences for the banking sector, especially when they rise too fast or too high.
Banks make money by borrowing at low rates and lending at higher rates, earning a profit from the difference.
When interest rates rise, banks have to pay more to their depositors and bondholders, while their existing loans become less valuable and harder to sell.
This squeezes their profit margins and reduces their capital buffers.
Moreover, higher interest rates can also trigger defaults and bankruptcies among borrowers who cannot afford to service their debts.
This increases the risk of loan losses and bad assets for banks.
When banks face financial distress, they tend to tighten their lending standards and reduce their credit supply.
This further slows down the economy and reduces income and spending. It also creates a vicious cycle of fear and uncertainty among depositors and investors, who may lose confidence in the banks’ ability to honor their obligations.
This can lead to bank runs, where people rush to withdraw their money from the banks before they run out of cash or go under.
This can cause a liquidity crisis or a solvency crisis for banks, depending on whether they have enough cash or assets to meet their liabilities.
Safeguards are in Place
The good news is that there are safeguards in place to prevent such scenarios from happening or escalating.
The most important one is deposit insurance, which guarantees that depositors will get their money back up to a certain limit if their bank fails.
In the U.S., this limit is $250,000 per depositor per bank, which covers most individuals and small businesses.
Deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC), an independent agency that monitors and regulates banks and intervenes when they become insolvent or illiquid.
Another safeguard is the lender of last resort function of the Fed, which means that it can provide emergency loans to banks or other financial institutions that face temporary liquidity problems but are otherwise solvent.
The Fed can lend at a penalty rate against collateral to prevent banks from collapsing due to cash shortages or panic withdrawals.
The Fed can also use its monetary policy tools to inject liquidity into the financial system or lower its interest rate to ease financial conditions and support economic activity.
These safeguards have been tested and proven effective during previous episodes of banking crises, such as the Savings and Loan crisis in the 1980s or the Global Financial Crisis in 2008-2009.
They have prevented widespread bank failures and systemic contagion that could have caused much more damage to the economy and society.
Conclusion
Therefore, there is no need to panic or rush to withdraw your money from your bank account.
Your money is safe as long as your bank is insured by the FDIC and regulated by the Fed.
You can check if your bank is insured by visiting https://www.fdic.gov/bankfind/ or calling
Category: Banking
