To The Moon

How will the Federal Reserve balance price and financial stability? That's the question troubling the market ahead of next week's rate-setting Federal Open Market Committee meeting.

Before Silicon Valley Bank's sudden collapse last week triggered a banking crisis, the Fed had the luxury of focusing its attention on fighting inflation. Recession and financial crisis felt distant.

No longer. The Fed opted to close multiple banks, cover uninsured deposits, and launch an emergency liquidity facility. Those actions revealed a potential dilemma: Policy could be too tight for the financial system but still not tight enough for the wider economy.

In this awkward situation, monetary policy is pulled in two directions. Tightening policy further would help bring inflation back down to acceptable levels, but it could further destabilize the banking system. The two goals are in tension.

The Fed has responsibility for both, so what will it do? There is no playbook, but it will do as much and as early as it can on the banking system so it has space to maneuver on inflation.

The Fed's initial response -- already in motion -- will be to shore up the banking system. Joint actions by regulators over the weekend will help ringfence risk so it doesn't spread. The hope is that, in doing so, the financial system will be able to withstand even tighter policy without buckling.

If last weekend's intervention doesn't suffice, the Fed can reach further into its arsenal and do more along the same lines. It can put its balance sheet to use and strengthen capital and liquidity requirements. Congress and other regulators might even help.

Should those measures fail to stem contagion in the banking system, the trade-off becomes more treacherous. Data released Tuesday showed core consumer price inflation up 0.5% last month. With inflation still high, it is doubtful the Fed can afford to take a break from the inflation fight.

Policy makers have been warned that keeping policy easier for the sake of financial stability, even if only temporarily, could come back to haunt them. Inflation expectations could spike again and that psychology could take hold. Tolerating higher inflation might only pave the way for an even bigger financial stability problem down the road. But letting a financial crisis spiral isn't a solution either.

The good news is Fed officials are willing to adapt its crisis playbook beyond the last two episodes, which both featured recession and an easing cycle.

Just as the Fed was unable to lower the policy rate below zero in 2008, it is now unwilling to lower the policy rate because of inflation risk. By the same token, when events flare up, the Fed comes up with surgical fixes when easing policy across the board isn't an option.

The latest interventions buy time for the financial system to adjust, rather than coming as a shock all at once. The Fed's hope is that minor bumps in the road don't turn into potholes that cause catastrophe.

Failing that, the Fed could be facing a much bigger challenge: relentless inflation, sputtering growth, and a financial system that is bleeding trust. Let's all hope it doesn't come to that.