Despite a year of recession calls by many, the U.S. economy came into 2023 with strong momentum. While the headline GDP number for the first quarter was only 1.1%, that was entirely due to the anticipated rundown in inventories. Final demand—the sum total spending by consumers, business, and government—grew at a 3.2% annualized real pace, the highest level in almost two years. Consumer spending led the way, which is not surprising once you accept the reality that excessive consumer demand is what drove inflation in the first place—rather than consumers being hurt by it, as the standard narrative goes. (To be fair, some consumers are of course under pressure due to inflation. But overall, consumer demand is greater than the economy’s ability to meet that demand. As the old truism goes, inflation is nothing more than the consequence of too many dollars pursuing too few goods.)
Sure, labor markets have cooled slightly, but only insofar as the job openings rate fell below 6% for the first time in two years; it’s still at a record high level relative to any point prior to the pandemic. Moreover, the U.S. unemployment rate has dropped to 3.4% in the most recent data, the lowest level since 1969. Workers’ earnings growth remains solid, particularly for lower skilled workers. Even asset markets have started to pause their swoon. The Case Shiller index indicates home prices rose in March for the first time since June 2022. In short, we seem pretty far from dipping into this most anticipated of recessions.
All this strength has happened even as the Fed raised the Federal Funds rate from 0% to a hair over 5% in response to the bout of inflation the nation has experienced over the past year. It’s the most rapid increase in this policy lever since Paul Volker held the Fed Chairman seat. Inflation has indeed slowed, and yet the economy is still growing. That said, it should be a relief that after their May meeting the Fed announced they would be stopping their rate increases for now. UBS’s chief economist Paul Donovan summed it up: “[t]hank goodness that’s over”.
We should probably put those champagne bottles back in the refrigerator, for now. As I’ve noted in past posts, the Federal Funds rate (and the short run interest rates it drives) are not the critical issue in today’s economy. Private sector debt levels are relatively low, and there is still plenty of cash floating around, reducing the need for short-term borrowing. Indeed, despite the rapid hike in interest rates, debt markets remain remarkably clean. There are still almost no foreclosures in the U.S. housing market, and although delinquency rates on credit card debt are rising, they’re only doing so from the record-low levels hit during the pandemic. In the 4th quarter of 2022, the delinquency rate on the loan portfolio in the U.S. commercial banking system hit an all-time low of 1.19% according to the Federal Reserve data.
Given the collapse of three major banks in recent weeks, this all begs the question: Why are banks failing if the economy is so strong?
As I pointed out in my last post on Fed policy, the issue today is less about the cost of credit and more about the supply of deposits. And on this front, the Fed was perfectly clear that they are going to continue their efforts to make credit even scarcer: “the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans.” In short, quantitative tightening will continue, and this means the stresses on U.S. banks will only get worse. To see why, consider how the Fed has changed policy and how that has impacted the depository system.
- In early 2020, in response to the pandemic, the Fed decided to institute $5 trillion in quantitative easing. This caused interest rates to fall, and bank deposits to grow by a proportionate amount.
- In late 2020 and 2021 banks made trillions of dollars in loans at low interest rates but they still had enormous quantities of excess cash reserves, which they used to buy debt securities at relatively high prices (low interest rates).
- In early 2022 the Federal Reserve started increasing the Federal Funds rate, and interest rates rose sharply. The value of existing loans and securities being held as assets within the banking system fell proportionately in value.
- In late 2022 the Federal Reserve begins quantitative tightening, causing bank deposits to decrease. Banks suddenly find themselves with diminished reserves and have to either secure expensive injections of external capital or sell off balance sheet assets at a loss.
Both Silicon Valley Bank and First Republic Bank failed because they had some of the largest increases in deposits due to their location in Silicon Valley, where so much of the new money that was injected into the economy from quantitative easing ended up. This implies that they experienced the largest losses relative to their overall asset base and that they saw proportionately large declines in their reserves when quantitative tightening began. They weren’t victims of bad management; they were victims of the wrong geography. But remember, all banks are suffering from the same pressures at some level, and this is what’s causing credit conditions to violently tighten.
The Fed’s Senior Loan Officer Survey shows banks dramatically tightening standards on lending, increasing their rates over their cost of funds, and in general, desperately trying to conserve cash. This hasn’t had an impact on the broader economy… yet. Keep in mind that the Fed has reduced its balance sheet by less than half a trillion dollars—just 10% of the $5 trillion it put into the economy. Given that the Fed will continue its money supply reducing efforts in the months ahead via quantitative tightening, we can anticipate even tighter credit and more bank failures.
Beacon Economics’ expectation is that over the next few months short run interest rates will stabilize, but long run rates will again start to rise. Real estate will also begin to swoon and that will only intensify the current issues affecting commercial real estate finance. We don’t believe this will hurt the consumer much in the short term—after all, it’s households that are hanging on to a huge share of the extra cash that’s still out there. But the troubles in real estate could expand into other parts of the credit markets, and this could set off an economic crisis in its own right, one that might cause the recession everyone has been fearing over the last year for all the wrong reasons.
Ultimately, the real question is why? Giving excessive amounts of money to consumers is what caused inflation in the first place. Taking money from the banks now to try and slow inflation is ultimately pointless. But in a world where political narratives dominate economic facts, this means little. To the politicians who now run the Federal Reserve, appearance is vastly more important.
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