Less than a week ago, the cyclical playbook for executives looked pretty straightforward. To prevent inflation from becoming strong, the Fed will continue to raise rates and leave them higher.
Somewhat surprisingly, the strong US economy has absorbed the wind and has a good chance of squeaking by 2023 without a recession. The first episode of a myth Soft landing playing, even without challenges for companies.
However, the collapse of Silicon Valley Bank (SVB) and its effects cut that playbook-at least in the eyes of the markets, as seen in the dramatic shift in interest rate outlook. Last week, the markets believed that the Fed would raise the policy rate to around 5.75% and not cut it before early 2024. Now, the stress in the banking sector has shifted to the rate betting market. in cuts as early as June 2023 and will rise below 5%. The recessionary outlook has returned to market prices.
This raises a dilemma for the Fed, which is now grappling with two structural—and parallel—risks at once. It must continue to fight inflation while ensuring that rising rates do not undermine financial stability. To protect the inflation regime and prevent a banking crisis, the Fed should push in the opposite direction. A recession, already a high risk but not a certainty, could destroy this trade-off—and its likelihood has increased.
The return of financial instability
When the Fed began last year’s fastest rate hiking cycle since the early 1980s, there was always the risk of breaking something. There is a reason that monetary policy prefers to act slowly and cautiously, but accelerating and expanding inflation demands a steeper rate path. It also ended a decade of ultra-low rates, which exacerbated the risk of a crack. With the collapse of SVB and Signature Bankthe knock-on effects have already reached the banking system.
However, the SVB debacle is not a re-run of the 2008 banking failures that are still fresh in our memories. There are no piles of bad assets accumulated through lax lending and bad credit underwriting. Instead, the risks lie in how the bank invests the fast-growing deposits of its mostly venture capital clients. It plows billions in deposits, which can be withdrawn at any point, into long-term government bond funds.
A large mismatch in maturities never looked wise, but it became the downfall of the bank when the rapid rise in interest rates reduced the value of these bond holdings. When depositors began to withdraw their deposits, SVB had to sell these securities at a lower price and was forced to raise capital to cover the shortfall. It may have been successful, but the magnitude of the loss scared off depositors, undermined plans to raise capital, and the rapid run quickly led to the bank’s closure.
Less complicated than the 2008 crisis, the SVB saga is a textbook example of a bank run—exactly what the Federal Reserve, created in 1913, was designed to solve. And they acted quickly and decisively to ease the banks’ funding problems. The conditions of the Discount Window, the rate at which banks can borrow in the short term, were eased and the Fed opened the new Bank Term Funding Program (BTFP). This allows banks to borrow–at par value–against the kind of high-quality securities that got SVB into trouble (US Treasury and agencies don’t lose value when held to maturity).
However, these measures did not immediately relieve the stress on the US banking system. The lack of a clear deposit guarantee above $250,000 means deposit flight continues to put pressure on other mid-sized banks, such as First Republic, which have mostly commercial clients. . Although FDIC deposit insurance may be sufficient for most individuals, it is not sufficient for smaller companies. And despite the additional facilities launched by the Fed, the middle-sized banks look reduced in the eyes of customers and investors.
Deposit flight continues as customers have little incentive to stay, instead looking to move their deposits to “too big to fail” banking behemoths. Similarly, investors have little incentive to own large amounts of stocks in banks with an uncertain business model for the future. Their stock prices collapsed, and sales were halted for some.
The Fed is now fighting on two structural fronts
Although currently nowhere near the stress of 2008, the return of financial instability has darkened a cloudy cyclical outlook by making the work of central bankers more difficult. difficult. While the Fed is focused on avoiding a structural break in the inflation regime by lowering cyclical inflation, it now also needs to manage financial stability risks. This represents a new—and conflicting—set of challenges.
As we saw with the demise of the SVB, the basic policy prescription to fight inflation–hiking interest rates–is also a key driver of financial instability, because rising rates reduce the value of bond holdings. However, cutting rates to prevent more risks to financial stability undermines the desire to cut inflation out of the economy. While the discontinuity of the inflation regime works much more slowly than the sudden and surprising nature of a banking crisis, its toxic long-term effects can be just as bad—or worse.
Of course, the Fed’s concern is more complicated than deciding between raising and cutting rates to address the twin risks—which is good news. First, its toolset is not limited to interest rates. This is especially true when it comes to bank funding and liquidity risk because the central bank’s balance sheet provides a huge amount of firepower. Quantitative easing (QE) has shown this over and over again and the Fed’s new Bank Term Funding Program enhances the possibility that policy may ease here (funding/liquidity) while tightening there (policy rates).
Second, the fight against inflation is not just about interest rates. Monetary policy works by controlling the economy through the amorphous force of “financial conditions,” which include ease of access to credit. And if banks pull back from issuing credit because of capital and liquidity concerns, financial conditions will tighten even as prices fall. In other words, the resulting slowdown means that the fight against inflation can continue even if rates fall.
The economic risk is higher now
The new reality of balancing the risks of financial stability with the risks of structural inflation undoubtedly pushes the possibility of an economy. To be clear, the risk of recession has been raised before the financial stability challenge, but far from inevitable. The US labor market continues to show remarkable strength—and it remains the case that a sharp increase in the unemployment rate is the only true arbiter of a recession.
But for anyone who believed the risk of a recession to be high last week, it’s hard to believe the risk is anything other than continuing higher. Even if the acute phase of funding stress (deposit runs) passes, we must remember that monetary policymakers are most successful when they are able to move slowly and see how their policy is absorbed in the real economy. Quick shocks of confidence, fees, equities, or funds that must be included in an uncertain policy-making process are not a recipe for success.
Could a recession be a blessing in disguise?
Although recessions should generally be avoided, they can be helpful and even necessary if cyclical stress is plausibly threatening to become a structural break. A near-term recession may be less damaging than a long-term structural collapse of the inflation regime or a crippling banking crisis.
Of course, an immaculate soft landing with low inflation, low rates, financial stability, and rock-bottom unemployment rates is the preferred path. But if it becomes clear that it is not possible, then the choice for a recession will be better, especially if the prospects for a mild one.
A terminal recession resulting from the failure of the inflation defense regime will lead to a period of stagflation, while a recession driven by financial instability will leave a significant structural deterioration. and overhangs in the real economy. Conversely, a mild recession that resets inflation to lower levels and reduces risks to financial stability would be better. The time for such a reset has not yet come—but the crisis we face brings us closer to such a scenario.
Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist.. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.
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