ABOUT THE AUTHORA member of Putnam's Fixed Income team since 2007, Onsel Gulbiten analyzes macroeconomic issues, including inflation, interest rates, and policy developments.
- Sudden financial stability issues are beginning to cast doubt on the resilience of the U.S. economy.
- A recession in 2024 is still the most likely outcome.
- The Fed will be walking a thin line between financial stability and inflation.
Rising financial stability concernsThe labor market is tight and inflation is high, but the recent bank failures (Silicon Valley Bank (SVB) and Signature Bank) plus the Credit Suisse issues in the background have brought financial stability concerns to the forefront. The Federal Reserve, the U.S. Treasury, and the FDIC jointly acted to minimize further contagion to other financial institutions or markets. Given the inflationary backdrop, the Fed surely desires to separate financial market stability from the dual mandate of growth and price stability, which lately has been reduced to inflation targeting.
Emergency action points to next thresholdThe Fed, the Treasury, and the FDIC acted quickly but avoided providing a full spectrum of guarantees or support. The guarantee to all depositors of the failed banks raised the expectation that authorities would do the same if another bank fails, but it fell short of providing the blanket deposit guarantee that some market participants were looking for. The Fed's new Bank Term Funding Program, where banks will be able to pledge high-quality securities for cash at par value, may support banks with large holdings of Treasuries and mortgage-backed securities (MBS), but it may not be supportive enough for banks with lower-quality holdings. Another unexpected development could test the sufficiency of announced measures and the policymakers' commitment to financial stability.
Credit markets are keeping inflation aliveBefore the U.S. regional bank worries surged, bank senior officers were already tightening credit standards. This is an important component of the Fed's tightening efforts. Higher credit standards matter as much as the rise in rates in determining the supply of funding and the effective price of borrowing. Since late 2021, senior loan officers have been tightening credit standards, and demand has been responding to higher rates and standards. Credit growth has not turned negative yet but has recently begun trending down, as is typical in the early run-up to a recession.
Figure 1. Commercial and industrial (C&I) loan growth is not yet at the negative levels seen in past recessions
Measures of supply and demand for C&I loans
Source: Federal Reserve Board.
Capital markets, on the other hand, are wide open. High-yield corporate bond spreads, which historically widened as banks tightened credit standards, do not indicate stress in credit markets yet. If the recent policy actions prevent a financial contagion, global liquidity can remain high, asset values can remain elevated, and households can continue to feel comfortable about their future and spend money. In turn, high asset values, along with tight labor markets, can keep inflation sticky.
Private sector balance sheets could deteriorate, but not significantly enough to take us into recession or kill off inflation in the short run. Tightening of credit in the small and medium-size-bank channel will likely bring forward the timing of a recession given their importance to the commercial and industrial corporate segments. However, tightening in this channel is unlikely to materially impact both the sticky inflation problem and immediate growth prospects while the capital markets remain functional.
Figure 2. Credit markets remain open as high-yield spreads have not risen with banks' tighter lending standards
Credit standards for C&I loans and corporate high-yield bond spreads
Sources: Federal Reserve Board, Bloomberg.
The recent bank failures, potential deposit flight, and rising funding costs will impair banks' lending capacity going forward. The credit channel to businesses, especially to small and medium-size enterprises, may be significantly damaged. Recession concerns are likely to dominate Fed discussions going forward, even though there are a few hawks within the FOMC.
The Fed's possible moves and likely impactsIn light of these recent developments, the Fed could hike rates a little more or pause, but it cannot cut rates and still hope to bring down inflation. Further tightening in credit standards will likely contribute to slowing activity in the next few months. If the Fed signals that it is comfortable with the market's rate-cut expectations, Treasury rates would likely stay low, financial conditions would loosen, and the mark-to-market losses would ease. However, if the Fed quickly eases before its tightening fully hits the real economy, the U.S. can indeed avoid a recession or experience a garden-variety recession, but inflation would stay.
It is also possible the Fed would choose not to repeat the mistakes of the 1970s or of the 1998 rate cuts that added to the dot-com bubble. In this scenario, the Fed's inflation-fighting objective could dominate. Financial conditions would tighten and asset values would come down further, in our view. Large drops in financial markets can, in fact, bring back a low-inflation, low-interest-rate environment. This might involve a deep recession or at least a large decline in asset values. However, the Fed may not be ready to take the most painful medicine at this moment.
This might not be the big oneThe Fed is known to hike until something breaks. It is not clear if something big enough is broken now. Yet, given the fragilities in financial markets, the Fed is likely to move cautiously as tightening seems to be finding its way into the economy and the end of the hiking cycle is in sight. If confidence in financial institutions is restored while the U.S. economy stays resilient, the Fed will have a chance to bring inflation sustainably down by maintaining high interest rates for a longer period. However, too much confidence in financial markets can make achieving the 2% inflation target harder. The Fed will be walking a thin line between financial stability and inflation.
With various indicators pointing to late cycle dynamics in place, our team maintains the base case of a 2024 recession with a 50% probability. Importantly, we believe recession is a necessary condition to take us out of this inflationary loop. The recession might be mild, but asset values need to decline a lot. Unfortunately, it still seems clear that only large drops in financial markets can bring back a low-inflation, low-interest-rate environment.