1. A tempest in a teapot, or a terrible tornado?
Current economic and financial market developments are a direct reflection of global central banks’ extraordinarily rapid and synchronized monetary policy tightening cycle, policy flip-flopping on the part of the Fed and idiosyncratic management and supervision issues in the banking sector.
While central bankers have continued to signal an intent to tighten monetary policy aggressively in the face of persistently elevated inflation, the private sector had yet to fully adapt to a world of higher interest rates. What we are now observing may be the gradual realization that a high cost of capital environment is here to stay.
Yet, we must be wary not to draw premature conclusions that today’s conditions will lead to a repeat of the financial crisis of 2008-09. We believe there are at least three factors that will distinguish the current episode: rates, regulation and policy response.
First, most of the immediate risk appears to be interest related rather than credit related. While there are certainly credit quality concerns on the consumer and business front, most of the stress in the banking sector reflects interest risk. Second, the global banking sector is much better capitalized and regulated (thanks to Basel and Dodd-Frank rules), with frequent stress tests being conducted and reviewed by financial authorities. In the US, the banking sector stress appears to be concentrated in a finite number of mid-sized depository institutions with undiversified deposit bases. Globally, some larger financial institutions have come under stress, which is pointing to potential contagion concerns, but the risks appear to be more idiosyncratic and confidence-based than related to credit risk concerns. Third, the policy and regulatory responses have been much swifter than during the 2008-09 financial crisis. The FDIC, Treasury and Fed response took only 48 hours, and the Swiss National Bank offered a liquidity backstop the same day Credit Suisse, Switzerland’s second-largest lender, faced significant market pressures.
2. Both “known unknowns” and “unknown unknowns” are risks
The “known unknowns” are twofold. First, there is the risk of contagion from the idiosyncratic stress on a finite number of banking institutions with a highly concentrated base of depositors and unhedged interest rate risk into large domestic and global systemic financial institutions, which could be the catalyst for a banking crisis. Emerging markets’ dollar funding conditions is another area to monitor.
Second, as the Federal Reserve’s Monetary Policy Report and Financial Stability Report indicate, there are risks posed by mutual funds’ investments in corporate bonds, municipal bonds and bank loans, given the relative illiquidity of their assets and the requirement that they offer redemptions daily. The reports also stress liquidity challenges faced by life insurers, whose asset liquidity declined while liability liquidity increased, and note that interest rate-sensitive sectors like commercial real estate contain elements of risk in an environment of elevated rates and reduced demand (especially for some sub-segments).
The “unknown unknowns” are by nature impossible to predict, but we know they exist and the pension funds stress in the UK last September, the cryptocurrency fallout and global banking sector stress are notable examples of the risks.
3. Fed can’t do everything, everywhere all at once
The Fed is in a very uncomfortable position: it can’t do everything, everywhere all at once. The elevated inflation backdrop means that it is in a very delicate situation compared with the past 40 years. Whereas the Fed had previously been able to discount the price stability risk and respond unswervingly to the financial stability risk, conditions today are very different with inflation still too high.
This is where market pricing appears misguided. Investors have been quick to price out much of the 100bps of federal funds rate increases over the next four months that were anticipated just a week ago, with odds of a 25bps rate hike at the upcoming March 21-22 Federal Open Market Committee (FOMC) meeting falling to 50%. What is more, bond investors are now pricing as much as 75bps of rate cuts before year end.
The major question for the Fed isn’t whether it should pause its tightening cycle – as a prudent risk management approach would suggest – but whether it will. And legacy may be the defining factor. Fed Chair Jerome Powell and most policymakers do not want their legacy to be a failure to bring inflation down to the 2% target.
As such, we believe the Fed may consider adopting a dual-track policy approach, similar to the European Central Bank (ECB), distinguishing monetary policy from macro-prudential policy. In doing so, the Fed would be able to continue tightening monetary policy gradually – likely in 25bps increments – while closely monitoring financial market developments and addressing risk concerns with its macro-prudential tools.
In our view, the optimal approach would be to pause the tightening cycle in order to assess economic and financial conditions over the next couple of months. This would permit a better anchoring of monetary policy to the totality of data rather than excessive backward-looking data dependence. The Fed could even suggest a hawkish or conditional pause, noting that if financial conditions normalize and economic data suggest the need for further tightening, it will resume rate hikes.
4. Clouded outlook, but generally weaker growth as a result of tighter credit conditions
Before the recent banking sanction stress, we noted that extreme data volatility had made the US economy more difficult to decipher. Our view was that tighter financial conditions and credit standards had led business executives to focus their investments and hiring decisions on growth opportunities, while managing pressures on margins via well-executed pricing strategies and efforts to enhance productivity.
Real GDP growth had slowed from 5.7% year over year (y/y) in Q4 2021 to 0.9% y/y in Q4 2022, with the persistent drag from higher inflation, a historically rapid Fed tightening cycle, tighter financial conditions and a deteriorating global economic backdrop weighing on housing activity, consumer outlays, business investment and international trade.
Still, labor market strength and consumer spending resilience through February indicate the absence of any significant retrenchment in private sector activity. The current developments will make banks more wary of lending, however, while also weighing on businesses’ decisions to hire and invest.
While it’s impossible to determine with any degree of precision how the current situation will evolve, we anticipate that, absent a financial crisis, tighter credit and financial conditions will represent a drag on the US economy worth around 0.5% of GDP over the next 18 months. As a result, we now anticipate real GDP growth will be closer to 0.8% in 2023 and around 1.5% in 2024. The multispeed economy will continue to feature a severe correction in housing activity, a manufacturing slump, softening of consumer spending and the onset of a destocking cycle in sectors with bloated inventories.
As to whether we will experience a recession, we believe recent events have notably increased recession odds. As noted previously, while the economic landscape may look benign one day, an abrupt shift in sentiment and financial conditions could lead to a recessionary environment the very next day if everyone starts retrenching. Amidst heightened financial market volatility, a pullback in hiring, postponed capex decisions and a turn in the inventory cycle can lead to a nonlinear shift into a recessionary regime.
The views expressed by the author are his own and not necessarily those of Ernst & Young LLP or other members of the global EY organization.
