Less than a week ago, the cyclical playbook for executives looked comparatively straightforward. To prevent inflation from becoming entrenched, the Fed would continue to hike rates and leave them higher for longer.
Somewhat surprisingly, the resilient U.S. economy absorbed that headwind and stood a good chance of squeaking by in 2023 without a recession. The first stage of a mythical soft landing was playing out, though not without challenges for firms.
However, the collapse of Silicon Valley Bank (SVB) and its repercussions has shredded that playbook–at least in the eyes of markets, as seen in the dramatic shift in the interest rate outlook. Last week, markets believed the Fed would hike the policy rate to about 5.75% and not cut it before early 2024. Now, the stress in the banking sector has shifted rate markets to bet on cuts as early as June 2023 and peaking below 5%. The recessionary outlook is back in market pricing.
This raises a quandary for the Fed, which is now fighting two structural–and interrelated–risks at once. It must continue to fight inflation while making sure that rising rates don’t further undermine financial stability. To protect the inflation regime and prevent a banking crisis, the Fed would need to push in opposite directions. A recession, which was already an elevated risk but not a certainty, could break this trade-off–and its probability just went up.
The return of financial instability
When the Fed embarked last year on the fastest rate hiking cycle since the early 1980s, there was always the risk of breaking something. There is a reason monetary policy prefers to move slowly and carefully, yet inflation’s acceleration and broadening demanded a steeper rate path. It also ended a decade of ultra-low rates, exacerbating the risk of a crack. With the collapse of SVB and Signature Bank, the knock-on effects have arrived in the banking system.
Yet, the SVB debacle is not a re-run of the 2008 banking failures still fresh in our memories. No piles of bad assets accumulated through lax lending and poor credit underwriting. Instead, the risks lay in how the bank invested the rapidly growing deposits of its predominantly venture capital clientele. It ploughed billions of deposits, which can be withdrawn at any point, into long-dated government bond funds.
A large mismatch in maturities never looks prudent, but it turned out to be the bank’s downfall when rapidly rising interest rates reduced the value of these bond holdings. When depositors started to draw down their deposits, SVB had to sell these securities at a lower value and was forced to raise capital to cover the shortfall. This might have succeeded, but the size of the loss spooked depositors, ruining the plan to raise capital, and a rapid run quickly led to the bank being shut down.
Far less complex than the mess of 2008, the SVB saga is a textbook example of a bank run–precisely what the Federal Reserve, created in 1913, was designed to resolve. And they have moved fast and decisively to ease the funding problems for banks. Conditions at the Discount Window, the rate at which banks can borrow short term, were eased and the Fed opened a new Bank Term Funding Program (BTFP). It allows banks to borrow–at par value–against the type of high-quality securities that got SVB into trouble (U.S. Treasury and agencies do not lose value when held to maturity).
Even so, these moves have not immediately quelled the stress in the U.S. banking system. The lack of explicit deposit guarantees above $250,000 means that deposit flight continued to put pressure on other mid-sized banks, such as First Republic, with predominantly commercial clientele. Though the FDIC’s deposit insurance may be enough for most individuals, it is insufficient for even smaller firms. And even with the additional facilities the Fed has launched, mid-sized banks look much diminished in the eyes of customers and investors alike.
Deposit flight continues because customers have little incentive to stay, instead looking to move their deposits to banking behemoths that are “too big to fail”. Similarly, investors have little incentive to richly value stocks in banks with an uncertain business model for the future. Their stock prices collapsed, and trading was halted for some.
The Fed is now fighting on two structural fronts
Though currently nowhere near the stress of 2008, the return of financial instability has darkened a cloudy cyclical outlook by making central bankers’ job even harder. Whereas the Fed was focused on avoiding a structural break in the inflation regime by bringing down cyclical inflation, it now must also manage financial stability risks. This represents a whole new–and contradictory–set of challenges.
As we saw in the demise of SVB, the basic policy prescription to fight inflation–hiking interest rates–is also a key driver of financial instability, as rising rates reduce the value of bond holdings. Yet, cutting rates to prevent more financial stability risks would undermine the quest to wring inflation from the economy. While an inflation regime break plays out more slowly than the sudden and dramatic nature of a banking crisis, its toxic long-term impact would be just as bad–or worse.
Of course, the Fed’s quandary is a little 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 particularly true when it comes to bank funding and liquidity risk because the central bank balance sheet provides an enormous amount of firepower. Quantitative easing (QE) has shown this repeatedly and the Fed’s new Bank Term Funding Program improves the possibility that policy can ease over here (funding/liquidity) while tightening over there (policy rates).
Second, the fight against inflation is not only about interest rates. Monetary policy works by exerting restraint on the economy through the amorphous force of “financial conditions,” which includes the ease of access to credit. And if banks are pulling back from issuing credit because of capital and liquidity concerns, financial conditions will tighten even if rates are falling. In other words, the resulting slowdown means the fight against inflation could continue even if rates were to fall.
Recession risk is now higher
The new reality of having to balance financial stability risks with structural inflation risks undoubtedly has pushed up the likelihood of a recession. To be clear, recession risk was already elevated before the challenge of financial stability arose, but far from inevitable. The U.S. labor market continues to display remarkable resilience–and it remains the case that a sharply rising unemployment rate is the only true arbiter of a recession.
But for anyone who believed recession risk to be substantial last week, it is hard to believe that risk is anything other than higher going forward. Even if the acute phase of funding stress (deposit runs) passes, we should remember that monetary policymakers are most successful when they are able to move gradually and see how their policy is absorbed by the real economy. Quick shocks in confidence, rates, equities, or funding that must be incorporated into an already uncertain policy-making process are not a recipe for success.
Could a recession be a blessing in disguise?
Though recessions are generally to be avoided, they may be helpful and even necessary when cyclical stress credibly threatens to turn into a structural break. A near-term recession may be less damaging than a long-term structural downgrade of either the inflation regime or a crippling banking crisis.
Of course, an immaculate soft landing with lower inflation, lower rates, financial stability, and rock-bottom unemployment rates is the preferred pathway. But if it becomes clear that is not possible, then opting for a recession may be preferable, particularly if the prospects are for a mild one.
An eventual recession that comes out of failure to defend the inflation regime would lead to an era of stagflation, while a recession driven by financial instability would leave significant structural scarring and overhangs in the real economy. In contrast, a mild recession that resets inflation to lower levels and reduces risks to financial stability could be preferable. The timing for such a reset has not yet arrived–but the crisis we’re in has moved 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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