The Federal Reserve is getting unwanted help in its bid to slow the US economy and defeat the worst inflation in four decades: a cut in bank lending.
The upheaval in the financial system following the collapse of two major US banks increases the likelihood that lending standards will become significantly tighter. Less credit would mean less spending by consumers and businesses. This in turn would make it more difficult for companies to raise prices, thereby reducing inflationary pressures.
At the same time, some economists fear the slowdown could prove so severe that the economy slides into a painful recession.
On Wednesday, the Fed raised interest rates for the ninth time in just over a year. Central bank policymakers are grappling with a persistently high rate of inflation that has plagued American budgets and heightened uncertainty over the economy. US inflation remains well below last year’s peak at around 6%, but is still well above the Fed’s 2% target for the year.
But the Fed also signaled that it could be nearing the end of its rate hikes. This is partly because a reduction in bank lending could help the central bank meet its overriding goal of slowing the economy and taming inflation.
At a press conference Wednesday after the Fed’s announcement, Chair Jerome Powell suggested that tighter lending standards leading to credit being pulled could have the same dampening effect on inflation as a Fed rate hike.
“It doesn’t all have to come from rate hikes,” Powell said. “It may come from tighter credit conditions.”
After the European Central Bank raised its own interest rate by a sizeable half a percentage point last week, its President Christine Lagarde said the ECB would not commit to a pre-determined plan for rate hikes and that future rate decisions would be made on the basis of meetings.
Fears surrounding Europe’s banking system “could impact demand and actually do some of the work that could otherwise be done by monetary policy,” Lagarde said just days after the collapse of two major US banks and the Swiss’s demand Banking giant Credit Suisse rescued by competitor UBS.
If Europe does experience a credit crunch, analysts say last week’s ECB rate hike could be the last for a while.
ECB officials said their banks are “resilient” and have sufficiently strong capital buffers and cash to cover any deposit withdrawals they face. European regulators have applied international standards and are demanding more available cash. In contrast, US regulators have exempted all but the very largest US banks. Silicon Valley Bank was one of those exempt banks.
And when credit is more expensive and harder to get, consumers, who are driving most of the US economy’s growth, will spend less.
Gregory Daco, chief economist at consultancy EY-Parthenon, said he believes a significant credit tightening would have “slightly more” economic impact than the quarter-point rate hike the Fed announced on Wednesday.
Edward Yardeni, an independent economist, said he would estimate the impact would be even larger — the equivalent of a full percentage point hike by the Fed.
This could slow inflation and help the central bank meet its long-term goal. But the toll on economic growth could also be significant. Most economists have said they expect a recession in the United States in the second half of this year. The main question is how hard it could be.
Even before the Silicon Valley bank collapsed on March 10, signs of a possible credit crunch in the United States had been looming, raising concerns about the stability of the financial system. With interest rates rising and the economic outlook deteriorating, banks became more cautious about approving loans to companies as early as late 2022, according to a Fed survey of bank credit officers.
And banks’ “commercial and industrial” lending to businesses fell last month for the first time since September 2021, the Fed said.
Since then, the pressure on the banks has only increased. Silicon Valley Bank, the country’s 16th largest bank, failed after racking up huge losses on its bond portfolio, causing worried depositors to flee their funds. Two days later, regulators shut down New York-based Signature Bank.
The Federal Deposit Insurance Corporation, which insures bank deposits up to $250,000, said banks were sitting on $620 billion in paper losses in their investment portfolios late last year. This was mainly because higher interest rates had greatly reduced the value of their holdings in the bond market.
Powell said Wednesday the banking system is “solid” and “resilient.” However, fears remain that more depositors will pull their money out of all but America’s largest banks, increasing pressure on financial institutions to lend less and conserve cash to handle withdrawals.
Tight banks lined up this week to borrow money from the Fed. The Fed said Thursday that emergency lending to banks fell slightly last week — to $164 billion — but remained elevated.
More than $110 billion in loans went through a long-running program called the “discount window.” That was down from a record $153 billion the week before. Banks can borrow money from the discount window for up to 90 days. In a typical week, they only borrow about $5 billion this way.
The Fed also lent nearly $54 billion last week from a special lending facility it set up two days after Silicon Bank collapsed. That was an increase from nearly $12 billion the week before — when the program was just being set up.
Banks with less than $250 billion in assets account for about half of all business and consumer loans and two-thirds of home mortgages, noted Mark Zandi, chief economist at Moody’s Analytics.
“Credit is really the grease that oils the US economy and allows it to function and grow at a steady pace,” Daco said. “Without credit — or with slower credit growth — we’re likely to see companies being more hesitant about investment decisions and hiring decisions.”
Tightening bank lending, he said, “significantly increases the risk of a recession.” ____
` Business Writer David McHugh in Frankfurt and ` Economics Writer Christopher Rugaber in Washington contributed to this report.
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