Bank failures have been added to the equation. Economic conditions militated in favor of an additional increase of 50 basis points. Last week’s banking panic would have called for a pause, which would have had the opposite effect by heightening fears of a more systemic malaise in the US banking world. The Federal Reserve opted for the compromise of a 25 basis point increase in its key rate, pushing it into the 4.75%-5% range.
The statement from the Federal Reserve (Fed) was intended to be rather laconic, even robotic. “Recent indicators point to modest growth in spending and output. Job creation has peaked in recent months and continues at a robust pace. The unemployment rate is at a low. The inflation rate remains high. The US banking system is strong and resilient. Recent developments should result in tighter credit conditions for households and businesses, and weigh on economic activity, inflation and hiring. The extent of these effects is uncertain. The Federal Reserve’s Monetary Committee remains attentive to the risk of inflation. That’s the gist of the message.
The Federal Reserve had its finger between a rock and a hard place with the appearance of tensions in the banking system caused by the failure of three regional banks in less than two weeks and the forced takeover of Credit Suisse which had been faltering for more than a year. It therefore had to recall its dual mandate of price stability and full employment. And that, as a lender of last resort, it has tools other than interest rates in the form of programs to ensure liquidity in the financial system and to mitigate the risks of large-scale banking instability ladder.
The labor market remains tight and inflation remains high in the United States, particularly in the service sector excluding components related to housing. In this segment, the pressure on prices is mainly fueled by the strength of economic activity, even by the robustness of the labor market and, by extension, the increase in wages. In its fight against rising prices, the Fed is trying to prevent the persistence of a rise in off-target inflation from fueling a wage-price spiral. Fed Chairman Jerome Powell has on a few occasions referred to the bad experience of the late 1970s-early 1980s, when the institution made the mistake of taking a premature break only to then have to tighten more sharply, Oxford recalls. Economics, for whom a break today would have caused a communication problem. Mr. Powell had to be consistent.
Especially since financial tensions will have the effect of accentuating the impact of monetary tightening and the deterioration of credit conditions and the cost of credit, warned Monday the President of the European Central Bank, Christine Lagarde, a reading taken up on Wednesday by the Fed. Oxford Economics agrees, citing restricted lending practices that are weighing on the availability of credit and weighing down the US economy. Economic activity should already feel the full effect of the monetary austerity that began in March 2022 this year. The analysis firm’s model calculates that the impact of the sudden tightening of credit conditions peaks three months later. . And if a moderate recession in the second half of the year remains its base scenario, this additional stress, by somehow complementing the work of the Fed, could result in a more severe contraction.
Idiosyncratic risk
According to Oxford data, regional banks camp outside the 25 largest banking institutions in the United States, with the former typically having assets of $150 billion or less. They hold less than 30% of all banking sector assets, but account for 37% of bank loans. In this regard, they were particularly active last year, capturing 14% of loan growth, compared to 7% for the big banks. In the commercial real estate sector alone, regional banks experienced a 27% increase in lending, compared to 3.7% for large institutions.
To complete the portrait and again according to Oxford data, of the 4.5 trillion dollars of loans in the balance sheets of regional banks, the bulk, or 2 trillion, comes from commercial real estate. The rest is divided primarily between the roughly $900 billion in residential mortgages, $800 billion in commercial and industrial loans, and $500 billion in consumer loans.
Moreover, the rapidity of the intervention of the American Treasury, the Federal Deposit Insurance Corp. and the Federal Reserve, including last week’s injection of more than US$300 billion in new loans to banking institutions to stabilize the industry and provide it with liquidity, lowers the likelihood that the recent panic will turn into a new financial crisis. “Regional banks remain under pressure, but the event of the last two weeks still borrows from idiosyncratic risk”, summarizes Oxford. Here we mean a specific risk that concerns a particular company or institution, as opposed to a systemic risk.