Yicai Global: How do you comment on the Fed’s current monetary policy? Can central banks strike a balance between addressing the inflation challenge and maintaining economic growth and financial stability?

Diamond: The Fed is now in a dilemma.

Since US inflation and inflation expectations are still high, the Federal Reserve has to raise interest rates, especially real interest rates, to curb inflation. However, higher interest rates are hampering banks' solvency.

To make matters worse, the Fed has been promising to keep interest rates low for an extended period of time. The Fed thought it was a free, extra credit. This was not the case and led to the collapse of Silicon Valley Bank.

Arguably, the Fed's mistake was not raising interest rates, but overpromising low rates in the future.

However, continuing to raise interest rates is still the current correct decision. Thankfully, interest rates should be near their peak.

Yicai Global: Do you think the Federal Reserve and the European Central Bank should maintain the inflation target at 2%?

Diamond: Adjusting the target inflation is a very difficult problem.

The reason why central banks set target inflation is to keep inflation expectations "anchored". That is, when inflation deviates from the target, no matter whether it is high or low, people can use this to expect that the Federal Reserve will take corresponding actions to raise or lower interest rates and guide inflation back to the target range.

At present, the US inflation rate (year-on-year increase in core CPI) is slightly below 5%. If the Fed raises the inflation target from 2% to 3%, it means that actual inflation may soar to more than 5%.

Let's assume that when U.S. unemployment soars to 15% and inflation fails to fall back to 2%, at that point the Fed might say, "Okay, that's enough. 3% will be the new target inflation." Indeed, it would is the central bank's last option because it means admitting defeat.

In my opinion, the best approach is that when inflation falls back below 2.5%, the Fed can declare that 2.5% is close enough to the target, and use this as the new inflation target.

Ignoring the market is not the solution

Yicai Global: To what extent can we attribute the regional banking crisis to the Fed’s aggressive interest rate hikes?

Diamond: I think aggressive rate hikes are the main cause of regional banking crises. Especially when the Federal Reserve has already made a commitment to long-term low interest rates, aggressive rate hikes have violated the above-mentioned market expectations.

In fact, this risk is completely predictable. Previously, the UK government bond market has provided us with an excellent example. We can therefore expect that the same problem will occur in the United States if the Fed implements a large rate hike. This also does happen.

With the benefit of hindsight, if I were in the position of the San Francisco Fed, which is the regulator of Silicon Valley Bank and First Republic Bank, and realized that the benchmark interest rate was going to rise to 5%, I would take action to ensure that the above-mentioned banks remained at that rate. Solvency while requiring banks to raise capital or halt expansion. You know, the expansion of Silicon Valley Bank was unusually fast before.

Regulators should be aware of the shocks that monetary policy will unleash, but they are not. The two parties, regulators and monetary policymakers, seem to be separate and non-communicating, and they should communicate with each other.

Yicai Global: Taking the United States as an example, what measures do you think should be taken to prevent future banking crises and ensure the resilience of the financial system?

Diamond: Given that the current challenge is primarily interest rate risk, I think the best approach is for regulators to ensure that any operating bank is capital adequacy ratio of at least 7%, and it is measured in market value rather than book value. Book values may be inflated. You know, on the second day of the bankruptcy of Silicon Valley Bank, the capital adequacy ratio was nearly 14% in terms of book value. Therefore, we must use market prices.

The experience of the 2008 subprime mortgage crisis tells us that for illiquid assets such as mortgage-backed securities, it may not be necessary to use market prices for calculations, because this may be a sale price, or an estimate that cannot be traded price. Therefore, it is reasonable not to mark-to-market for such assets.

However, for mortgages and agency securities, it is unreasonable not to mark to market. First Republic Bank and Silicon Valley Bank are prime examples.

China Business News: Some critics of the Fed believe that it has been “hijacked” by the market to a certain extent.

Diamond: Investors' expectations of the Fed's policy will affect the market, and market performance will also have an impact on the Fed's decision-making. This feedback loop is what economists call a Nash equilibrium, and it's a fact.

But ignoring the market is not the solution.

The Fed needs to build some credibility on the policy path it is following. If everyone believes that the Fed will follow the policy path described above, it can drive some kind of market price formation. When this market price is not ignored by the Fed, everything works fine.

Once people think that the Fed's policy doesn't matter, it can trigger some crazy market prices. At this time, the Federal Reserve must respond to the above prices, and even be hijacked by market prices to deviate from its sensible decision-making.

Therefore, the Fed needs to develop and maintain a sensible decision-making mechanism so that the market can follow suit. At this time, there is no need to worry too much about the so-called "hijacking".

Yicai Global: How do you see the role of artificial intelligence and social media in the Silicon Valley Bank incident? Will social media change future crises?

Diamond: Social media accelerated the crisis because everyone knew about the bank run on day one.

However, I don't think social media triggered and caused the crisis. Social media is a two-way communication platform, we can all see what is tweeted and we can all tweet. As long as everyone can still communicate with each other, things won't be so bad.

the nature of the crisis

Yicai Global: Do you think that almost all crises are short-term debt crises. So, is the next crisis already on the horizon?

Diamond: The advantage of long-term debt and equity is that things evolve more slowly. Therefore, I can say that the next crisis will be a short-term debt crisis.

The essence of crisis is that everyone is eager to get out at the same moment, and the short-term debt crisis is its manifestation. As long as you run faster than everyone else, you are safe, which is the nature of a bank run.

In the case of Silicon Valley Bank, those who successfully withdraw cash on Thursday are the safest. If the Fed and the Federal Deposit Insurance Corporation (FDIC) are not able to stop losses in time, those who rushed to withdraw cash on Friday will suffer losses.

I think crises are by definition almost unpredictable. If the crisis can be perfectly predicted, we will definitely intervene and fix the problem in advance. It often happens where we don't worry about it.

In October last year, I predicted that the next crisis would be in the shadow banking sector or in mortgage lending. (As of now) it hasn't happened, it still could happen.