At an early January meeting of the Virginia Bankers Association, executives were already nervous that Federal Reserve interest rate increases were making it hard to compete for deposits.
“Everywhere I go in the industry people are feeling that kind of pressure,” the featured speaker of the day, Richmond Fed President Thomas Barkin, said in response to a question from the audience. The influence of Fed rate hikes “is going to hit…That is how it is designed.”
When Fed officials meet this week the suddenly urgent question is whether the level of pressure on the banking industry has become so great it risks a larger financial crisis – the sort of event associated with deep and hard-to-arrest economic downturns – and warrants a slowdown or pause to further rate increases.
The Fed and global central banks, after a tense 10 days with banks teetering in the US and Europe, launched a second round of weekend efforts to buttress the system by expanding the Fed’s ability to ship dollars where needed. Separately a deal was struck for UBS to acquire the troubled Credit Suisse in a takeover reminiscent of the global financial crisis 15 years ago.
After the announcement Treasury Secretary Janet Yellen and Fed Chair Jerome Powell issued their second Sunday afternoon statement of reassurance in as many weeks, saying as Asian markets prepared to open for the week that “the capital and liquidity positions of the US banking system are strong, and the US financial system is resilient.”
The issue for Powell and his colleagues is whether the calming words and a bank lending new program are enough to stem broader problems and allow them to proceed with what has been their priority to now: Combating inflation with the ever-higher interest rates now bedeviling the banking system.
If banking stress was to some degree hiding in plain sight, with deposits falling since the middle of last year and some common bank assets losing value as interest rates rose, the flashpoint was not hit until March 10 when the failure of the Silicon Valley Bank SIVB.O triggered doubts about the health of a swath of mid-sized banks and raised concerns of an old-fashioned deposit run.
Economists and investors so far expect the Fed to proceed with another quarter point interest rate increase at its March 21-22 meeting, but only because inflation poses such a persistent risk policymakers won’t want to divert from efforts to control it. The financial system, meanwhile, has been thrown extra support under a new Fed lending program for banks, while its traditional lender-of-last-resort cash window was tapped for a record $150 billion.
Fed officials gather this week having agreed bank stress poses a “systemic risk” to the economy, and “in any other hiking cycle this…would end the tightening process and perhaps send it into reverse,” said Ed Al-Hussainy, senior rates analyst at Columbia Threadneedle Investments. “The difference today is the Fed’s focus on inflation.”
In a recent Reuters poll 76 of 82 economists said they expect the Fed to approve a quarter point rate increase at this week’s meeting, lifting the target federal funds rate to a range between 4.75 per cent and 5 per cent. A similarly strong majority expect a further increase at a future Fed session.
The Fed’s policy statement will be released Wednesday at 2 p.m. (1800 GMT) along with closely watched projections from officials for the policy rate at year’s end, perhaps the best clue to how recent financial stress has reshaped the Fed’s outlook.
As of December officials expected the policy rate would rise to around 5.1 per cent by year’s end.
Worried about losing control over inflation that hit a 40-year-high 9.1 per cent in June, the Fed over the past 12 months increased rates at the fastest pace since former Fed Chair Paul Volcker faced an even worse outbreak of hot prices.
The experience of 1970s-era central bankers informed not only the extent of the rate increases, with the policy rate rising 4.5 percentage points from near zero as of last March. Powell and his colleagues also insisted the lesson from decades ago was that rates needed to rise to a restrictive level then stay there until inflation was defeated — not “stop and go” in a pattern of hikes and cuts they felt would not achieve price stability.
To many officials, the fact that inflation has been slow to respond to higher rates, while the economy has continued to grow and spin out hundreds of thousands of new jobs a month, was evidence rates needed to move higher still. Because nothing had “broken” in the economy, further rate increases were seen as cost-free.
On March 10 something broke, symbolically in the failure of the country’s 16th largest bank, but more broadly in the perception that the system might not be as stable as Fed officials have felt in the years since regulatory reforms forced financial firms to better buffer themselves.
None of those reforms prevented SVB from funneling its rapidly growing deposits into long-term government bonds that lost value as the Fed raised rates. That left the firm potentially short of the cash needed when depositors began to demand withdrawals — a dynamic the Fed worried could spread to other banks facing similar constraints.
For Fed policymakers the episode raises the possibility that they have repeated a mistake they had sworn to avoid and gone too far in raising rates.
The Fed’s recent policy statements have said that rate decisions would take into account “the lags with which monetary policy affects economic activity and inflation,” but until now respect for the delayed impact of past rate hikes has done little to change the Fed’s course.
Economists last week began marking down their growth forecasts anticipating that banking stress means a credit contraction lies ahead, with less money in the pockets of homeowners and businesses. To a degree that is what the Fed wants when it tightens monetary policy, as long as the drop in lending is orderly and doesn’t go too far.
“We expect that stress on smaller banks could result in a tightening of lending standards, exerting an incremental growth drag” on gross domestic product of as much as a half point, Goldman Sachs analysts wrote last week, among the few outside forecasters to say they expect the Fed to pause its rate hikes to take stock.
Markets are hardly settled. Even with a separate intervention by bank industry giants to shore up the books of the First Republic Bank (FRC.N), shares of the lender plummeted Friday amid broader stock market losses. The Fed has announced a review of its supervision at SVB to see if warning signs were missed.
Still, for the Fed “to pause here would provide no relief to the idiosyncratic issues for banks, and the Fed would risk losing all of the hard-fought progress made” in defending its 2 per cent inflation goal, wrote Jefferies analyst Tom Simons. “The optics of a pause remains unacceptably high.”