Banking Crisis Hangs Over Economy, Rekindling Recession Fear

Banking Crisis Hangs Over Economy, Rekindling Recession Fear

The US economic recovery has repeatedly defied predictions of an imminent recession, braving supply chain backlogs, labor shortages, global strife and the fastest rise in interest rates in decades.

That resilience is now being subjected to a new test: a banking crisis that appeared on the verge of turning into a full-blown financial crisis at times over the past week as oil prices plummeted and investors plowed money into US Treasuries and other safe-haven assets .

Markets calmed somewhat towards the end of the week on hopes that swift action by Washington and Wall Street leaders would confine the crisis to small and mid-sized banks, where it started.

But even if that were to happen — and veterans of previous crises warned that was a big if — economists said the episode would inevitably take a toll on hiring and investment as banks cut lending and businesses struggled as a result had to borrow money. Some forecasters said the turmoil had already made a recession more likely.

“This will have real and lasting economic impact even after the dust settles well,” said Jay Bryson, chief economist at Wells Fargo. “I would increase the likelihood of a recession given what happened last week.”

At the very least, the crisis has complicated the already thorny task facing Federal Reserve officials, who have been trying to gradually slow the economy in a bid to contain inflation. That task is as urgent as ever: government data on Tuesday showed prices continued to surge in February. But now policymakers must grapple with the risk that the Fed’s anti-inflation efforts could destabilize the financial system.

They don’t have long to weigh their options: Fed officials will hold their next regular meeting on Tuesday and Wednesday amid unusual uncertainty about what they will do. Just 10 days ago, investors were expecting the central bank to re-accelerate its rate-hiking campaign in response to stronger-than-expected economic data. Now Fed watchers are debating whether the meeting will end on unchanged rates.

The idea that the rapid rise in interest rates could endanger financial stability is not new. In recent months, economists have often remarked that it is surprising that the Fed has been able to raise rates so quickly and by so much without seriously disrupting a market that has become accustomed to low borrowing costs.

What was less expected is where the first crack began to appear: small and mid-sized US banks, which are theoretically among the most closely monitored and most tightly regulated parts of the global financial system.

Frequently asked questions about inflation

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What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar won’t go as far tomorrow as it did today. It is usually expressed as the annual change in the price of essential goods and services such as food, furniture, clothing, transportation and toys.

What Causes Inflation? This may be the result of increasing consumer demand. However, inflation can also rise and fall on developments that have little to do with economic conditions, such as E.g. limited oil production and problems in the supply chain.

Is inflation bad? It depends on the circumstances. Rapid price increases mean problems, but moderate price increases can lead to higher wages and job growth.

Can inflation affect the stock market? Rapid inflation usually spells trouble for stocks. Financial assets in general have historically performed poorly during inflationary booms, while tangible assets like houses have held up better.

“I was surprised where the problem came from, but I wasn’t surprised that there was a problem,” Kenneth Rogoff, a Harvard professor and leading expert on financial crises, said in an interview. In an essay in early January, he warned of the risk of “looming financial contagion” as governments and businesses struggle to adjust to an era of higher interest rates.

He said he doesn’t expect a repeat of 2008, when the US mortgage market collapse quickly engulfed virtually the entire global financial system. Banks around the world are better capitalized and better regulated than they were then, and the economy itself is stronger.

“To have a more systemic financial crisis, you usually have to drop more than one shoe,” Professor Rogoff said. “Think of higher real interest rates as a shoe, but you need another.”

Still, he and other experts said it was alarming that such serious problems at Silicon Valley Bank, the midsize California institution whose failure sparked the recent turmoil, could go undetected for so long. That begs the question of what other threats might be lurking, perhaps in less regulated areas of finance like real estate or private equity.

“If we can’t do that, then what about some of these other, more shadowy parts of the financial system?” said Anil Kashyap, a University of Chicago economist who studies financial crises.

There are already indications that the crisis may not be limited to the United States. Credit Suisse said on Thursday it would borrow up to $54 billion from the Swiss National Bank after investors dumped their shares amid fears about its financial health. The 166-year-old lender has faced a long string of scandals and missteps, and its troubles are not directly related to those at Silicon Valley Bank and other US institutions. However, economists said the violent market reaction was a sign that investors were increasingly concerned about the stability of the broader system.

The financial turmoil comes just as the economic recovery seemed to be gaining momentum, at least in the United States. Consumer spending, which had declined in late 2022, rebounded earlier this year. The housing market, which collapsed in 2022 amid rising mortgage rates, had shown signs of stabilizing. And despite high-profile layoffs at big tech companies, job growth has remained strong or even accelerated in recent months. By early March, forecasters were raising their estimates for economic growth and lowering the risks of a recession, at least for this year.

“Now many of them are reversing course. Mr. Bryson of Wells Fargo said he put the probability of a recession at about 65 percent this year, up from about 55 percent before the recent bank failures. Even Goldman Sachs, one of Wall Street’s most optimistic forecasters in recent months, said Thursday that the likelihood of a recession rose ‌10 percentage points to 35 percent as a result of the crisis and the resulting uncertainty.

Lending is likely to be the most immediate impact. Small and medium-sized banks could tighten their lending standards and lend less, either in a voluntary attempt to shore up their finances or in response to increased scrutiny from regulators. That could be a blow to residential and commercial developers, manufacturers, and other businesses that rely on debt to fund their day-to-day operations.

Janet L. Yellen, the Treasury Secretary, said Thursday that the federal government is “very carefully monitoring” the health of the banking system and broader credit conditions.

“A more general issue that worries us is the possibility that banks, when under stress, may be reluctant to lend,” she told members of the Senate Finance Committee. That, she added, “could make this a source of significant economic downside risks.”

Tighter credit is likely to pose a particular challenge for small businesses, which typically do not have direct access to other sources of funding such as the corporate bond market and often rely on relationships with bankers who know their specific industry or local community. Some could get loans from big banks, which so far have seemed largely immune to the problems of smaller institutions. But they will almost certainly pay more for it, and many companies may not be able to get credit at all, forcing them to limit hiring, investment, and spending.

“Replacing these small and mid-sized banks with other sources of capital could be difficult,” said Michael Feroli, chief US economist at JP Morgan. “That, in turn, could hamper growth.”

Slower growth, of course, is exactly what the Fed was trying to achieve by raising interest rates – and tighter lending is one of the main channels through which monetary policy is likely to work. If businesses and consumers scale back activity, either because it’s becoming more expensive to borrow or because they’re nervous about the economy, that could theoretically help the Fed bring inflation under control.

But Philipp Schnabl, a New York University economist who has researched recent banking woes, said policymakers have tried to rein in the economy by curbing demand for goods and services. A financial upheaval, on the other hand, could lead to a sudden loss of access to credit. The Tighter bank lending could also impact the overall supply in the economy, which Fed policy is making difficult to manage.

“We raised interest rates to affect aggregate demand,” he said. “Now you get this credit crunch, but that comes from financial stability concerns.”

Nevertheless, the US economy has sources of strength that could help cushion the recent setbacks. Overall, households have ample savings and rising incomes. Companies have relatively little debt after years of strong profits. And despite the struggles of their smaller peers, the largest US banks are on much stronger financial footing than they were in 2008.

“I still believe – and not only hope – that the damage to the real economy from this will be fairly limited,” said Adam Posen, president of the Peterson Institute for International Economics. “I can tell a very compelling story about why that’s scary, but it should be okay.”

Alan Rappeport and Jeanna Smialek contributed coverage.

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2023-03-17 18:02:55