ABOUT THE AUTHORA member of Putnam's Fixed Income team since 2007, Onsel Gulbiten analyzes macroeconomic issues, including inflation, interest rates, and policy developments.
While it remains unclear how much the recent banking crisis will add to the slowing of the U.S. economy, we believe the Federal Reserve should remain focused on bringing down inflation.
- Central banks prefer to separate financial stability issues from fighting inflation, especially given today's price pressures.
- If banking stress causes only a small tightening in financial conditions, interest rates could stay high for longer.
- In our opinion, the appropriate stance for the Fed is to maintain high rates while avoiding forward guidance as much as possible.
Separating financial stability from price stabilityThe day after Fed Chair Jerome Powell raised the possibility of a 50 basis-point hike in March, the market's focus shifted to financial stability issues. The failure of Silicon Valley Bank (SVB) and later of Signature Bank, with Credit Suisse concerns in the background, brought the banking sector worries to the forefront.
Especially in this inflationary environment, central banks prefer to separate financial stability issues from inflation-fighting objectives. What the Bank of England (BoE) did this past autumn is a good example. When U.K. pension fund stresses emerged, the BoE announced a temporary quantitative easing (QE) and purchased only long-maturity Gilts (U.K. Treasuries), while continuing to hike the policy rate. This temporary QE was able to restore financial market functioning, yet pension funds reducing their long-Gilt positions had to pay a higher price. Later, the BoE unwound all temporary QE purchases of September and October.
The U.S. banking chaos is different from the U.K. pension crisis in several respects. What started the banking issues in the first place was the cash burn some startups were experiencing. As projects started to fail or did not generate as much revenue as expected, those newly formed businesses resorted to relying more on the money they had raised earlier and deposited in bank accounts. As deposit outflows intensified, SVB had to raise cash, bringing the unrealized losses on its balance sheet to the front.
Although SVB had an unusual asset composition, with large marked-to-market losses due to the Fed's hiking cycle, this crisis happened exactly where one would expect, because the excessive pandemic stimulus had inflated the number of startups. Now that U.S. growth is slowing, partly thanks to interest-rate hikes, newly formed businesses are beginning to have profitability and viability concerns. More startups — in addition to older and larger businesses — are likely to have similar issues and will fail as U.S. growth declines more and the Fed's tightening cycle fully hits the economy. We seem to be only in the early stages of this adjustment; businesses still have some cash buffers, and loan losses have not been the main problem.
Figure 1. The large number of pandemic startups under profit pressure may withdraw bank deposits
U.S. new business applications and net business formation
Sources: U.S. Bureau of Labor Statistics and U.S. Census Bureau.
How pressure on banks could slow the economyThe banking sector stress can have an impact on the economy through three main channels: expectations, asset valuations, and bank lending. For businesses that have already been struggling to maintain profit margins, the change in expectations can accelerate layoffs. For households, the expectations channel is usually short-lived unless job losses accumulate. If unemployment starts to rise, consumption will weaken, exacerbating firm profitability issues.
Regarding asset valuations, with the regional bank stress, it became clear that the banking sector has been sitting on large unrealized losses. Deposit flight remains a risk, and banks have been raising deposit rates. Bank funding costs in retail as well as in wholesale markets have risen. Higher credit spreads and, hence, lower interest-rate margins, mean lower bond and equity values for financial institutions. Policymakers can intervene to restore financial stability, but as the Credit Suisse case shows, policy interventions may require private sector participation along the way. Financial stability can be maintained, but bank assets have to reflect higher risks and lower future earnings.
While financial institutions' bond and equity prices have come down, they do not seem to reflect an extended period of low profitability or higher regulation. While the current stress might be focused on small banks, banks of all sizes will be raising deposit rates to some degree, subject to more regulation, and paying for the increased cost of deposit guarantee insurance. Despite that, the market expectations of future earnings slowdown in financials have so far been in line with the other sectors.
A swift policy response can contain consumer and business expectations, and individual bank asset prices might have already priced in risks, but the recent developments are still likely to have a notable impact on the bank lending channel. Higher deposit rates and the necessity of recognizing the unrealized losses — whether sooner or later — have raised the credit spreads and reduced equity values. Declining interest-rate margins, along with the deteriorating outlook, are likely to make banks more cautious in lending. Lending capacity could be significantly impaired for smaller banks in particular.
Figure 2. Stress on banks can slow lending, but capital markets matter more
Share (in %) of U.S. bank lending in global capital
Sources: Federal Reserve Board, Bloomberg, and Putnam calculations.
Nobody knows how much of a tightening the banking stress will cause; only data will reveal over time. The impact of credit tightening might turn out less than feared. Bank funding costs might stay high, and the small-bank credit channel can be damaged, but large banks might take over some responsibility and extend credit while capital markets stay open. If the impact of the bank credit channel on the overall economy happens to be small, rates stay high for longer.
The outlook for Fed policyIn our opinion, the appropriate stance for the Fed, at this point, is to maintain high rates while avoiding forward guidance as much as possible, because the level of uncertainty is high. Whether the Fed can do that is a question: The Open Market Committee desires a soft landing and is worried about a recession.
If the Fed quickly eases the policy as the markets priced in March, equity and bond prices will rise, financial conditions will loosen, and banking sector unrealized losses will ease, but sticky inflation is likely to stay. If the U.S. recession does not arrive quickly, the Fed and markets will have to, once again, face the reality of high inflation. Alan Greenspan made this mistake in 1998 by easing after Long Term Capital Management (LTCM) collapsed and had to go back to tightening policy later, which brought an end to the dot-com bubble and the economic expansion. Even Paul Volcker made a similar mistake in 1980 by easing too quickly when the U.S. economy entered a recession that was not deep enough to kill off inflation. Volcker quickly reverted to hiking, inflicting another recession to end inflation.
The Powell Fed can make similar mistakes but can revert to tightening more quickly than Greenspan and Volcker did. The Fed may not need to hike more but may need to keep rates high for longer. Some communication mistakes are possible down the road, but we believe the Fed is likely to make the right decision in the end.