The Federal Reserve is getting some unwelcome assistance in its efforts to slow the US economy and combat the worst spell of inflation in four decades: a reduction in bank lending.
The financial sector turmoil caused by the failure of two large US banks increases the chance that lending criteria will become far more stringent.
Consumers and corporations would spend less if there were fewer loans.
This, in turn, would make it more difficult for businesses to raise prices, lessening inflationary pressures.
At the same time, other experts are concerned that the downturn may be so severe that the economy will enter a terrible recession.
The Federal Reserve hiked its key interest rate for the eighth time in less than a year on Wednesday.
The central bank’s officials are grappling with persistently rising inflation, which has befuddled American people and heightened the economic uncertainty.
At over 6%, US inflation is significantly below last year’s peak while still substantially beyond the Fed’s 2% annual objective.
Nevertheless, the Fed also hinted that it may be nearing the end of its rate rises.
This is due, in part, to the fact that a decrease in bank lending might assist the central bank accomplish its broader aim of slowing the economy and containing inflation.
At a press conference following the Fed’s announcement on Wednesday, Chair Jerome Powell warned that tighter lending criteria, resulting in a retreat in loans, may have the same dampening effect on inflation as a Fed raise.
“It doesn’t have to completely come through rate increases,” Powell added.
“That might be due to stricter financial conditions.”
Similarly, after the European Central Bank hiked its own benchmark rate by a significant half percentage point last week, its head, Christine Lagarde, stated that the ECB was not committing to a fixed rate rise schedule and that future rate decisions would be taken meeting by meeting.
Anxiety over the European financial system “could have an influence on demand and might actually undertake some of the job that would otherwise be done by monetary policy,” Lagarde said, just days after two large US banks failed and Swiss banking behemoth Credit Suisse needed a bailout from competitor UBS.
Moreover, if Europe experiences a credit crisis, many believe the ECB’s rate rise last week may be the last for a time.
According to ECB officials, their banks are “resilient,” with sufficient capital buffers and liquidity to cover any deposit withdrawals.
European regulators have implemented worldwide norms, requiring more readily available cash.
In comparison, US regulators spared all except the largest US banks.
Silicon Valley Bank was one of the exempted institutions.
Yet as loans become more expensive and difficult to obtain, consumers, who account for the majority of the growth in the US economy, are less inclined to spend.
Gregory Daco, chief economist at EY-Parthenon, believes a substantial credit squeeze would have “somewhat more” of an economic impact than the Fed’s quarter-point rate rise announced Wednesday.
Independent economist Edward Yardeni estimated that the impact would be considerably greater – the equivalent of a full percentage point raise by the Fed.
As a result, inflation may slow, assisting the central bank in meeting its long-term target.
Nevertheless, the cost to economic growth might be significant as well.
The majority of experts predict a recession in the United States by the second half of this year.
The important question is how serious it may be.
Even before Silicon Valley Bank failed on March 10, signs of a probable credit crisis began to appear in the United States, heightening concerns about the financial system’s soundness.
According to a Fed poll of bank lending officers, banks were already growing more cautious about providing corporate loans in the face of rising rates and a weakening economic outlook by the end of 2022.
According to the Fed, bank “commercial and industrial” loans to firms fell last month for the first time since September 2021.
The pressure on banks has only increased since then.
Silicon Valley Bank, the nation’s 16th largest bank, folded after accruing massive losses on its bond portfolio, prompting anxious depositors to withdraw their funds.
Two days later, New York-based Signature Bank was closed down by regulators.
The Federal Deposit Insurance Corporation, which guarantees bank deposits up to $250,000, said that at the end of last year, banks had $620 billion in paper losses in their investment portfolios.
This was partly because increasing interest rates have significantly lowered the value of their bond holdings.
Powell proclaimed the financial system to be “sound” and “resilient” on Wednesday.
Nonetheless, there is still concern that more depositors may withdraw their funds from all but the largest American banks, increasing pressure on financial institutions to lend less and hoard capital to meet withdrawals.
This week, cash-strapped banks were still lined up to borrow money from the Fed.
According to the Fed, emergency lending to banks dipped somewhat in the previous week, to $164 billion, but remained strong.
Around $110 billion in borrowing was routed through a long-standing mechanism known as the “discount window.”
This was down from a record $153 billion the previous week.
Banks can borrow for up to 90 days from the discount window.
In a typical week, they only borrow roughly $5 billion in this manner.
The Fed also financed approximately $54 billion from a special lending facility established two days after Silicon Bank failed.
This was an increase from over $12 billion the previous week, when the initiative was still in its early stages.
According to Mark Zandi, chief economist of Moody’s Analytics, banks with less than $250 billion in assets account for almost half of all business and consumer lending and two-thirds of all residential mortgages.
“Credit is basically the lubricant that fuels the United States economy and allows it to run and develop at a steady pace,” Daco explained.
“Without credit — or with slower credit growth — firms are likely to be more reticent when it comes to investment decisions and employment decisions.”
He stated that a restriction of bank credit “significantly raises the danger of a recession.”