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Good morning. The banking crisis of 2023 is over, hurrah! Or at least that is how markets acted yesterday. Bank stocks — even First Republic — rallied furiously, and the market as a whole followed. The yield on the two-year Treasury shot up by more than 20 basis points, suggesting the Fed might not have to worry quite so much about financial system failure as it sets monetary policy (more on this below). Admittedly, rates are not back to where they were before Silicon Valley Bank fell apart — but stocks are. There are still a lot of good vibes priced into this market. Email us: [email protected] and [email protected].
Minutes of the Unhedged Open Markets Committee
The Federal Reserve’s job is making tough calls but what it faces today is just ridiculous: containing a regional banking crisis of unknown proportions while wrestling down persistent inflation. It’s also supposed to issue economic projections to guide markets, but how? Should each Fed member estimate the number of banks they think will fail, and take the average?
The Fed’s immediate policy options:
A 50bp rate increase. Two short weeks ago, this was the odds-on favourite. Most now think this is too aggressive.
A 25bp increase. This is the current consensus view and would represent a split between stabilising the financial system and stopping inflation.
Pausing. Rates are already restrictive, and there is another Fed meeting in five weeks’ time. A wait-and-see approach would stop the central bank from adding to existing banking stresses.
A 25bp cut. The argument for this, made by Nomura’s Aichi Amemiya, hinges on financial stability being the dominant concern of monetary policy. Like a 50bp increase, this seems quite unlikely.
To debate one of the hardest monetary policy calls to date, we assembled what we think of as the Unhedged Open Markets Committee, which includes (along with Rob and Ethan, who serve as chair and vice-chair) Ed Al-Hussainy of Columbia Threadneedle, Dec Mullarkey of SLC Management, James Athey of Abrdn, Jim Sarni of Payden & Rygel and Claudia Sahm of Sahm Consulting.
Start with the consensus view, for a 25bp increase. Mullarkey argues that the Fed should pull apart its financial stability tools (eg, liquidity facilities) and inflation fighting tools (eg, rate increases):
The Fed should strive to separate . . . the risk of banking instability, which it has support to arrest, from inflation, which it still needs to corral. On balance if the Fed pauses, it could signal a lack of confidence in the banking system’s stability. Today’s stress is not about asset quality. It’s about liquidity concerns driven by the risk that depositors pull their money and force banks to abruptly sell assets. The only agents that can interrupt this cycle are the efforts of the Treasury with the Fed. And that is what they are doing through their liquidity lines. The current banking stress seems like a painful episode but is returning to normal. Meanwhile, inflation is a more threatening force which, if not tamed, could be a disrupter for decades.
Al-Hussainy agrees. He says that markets, through which monetary policy affects the real economy, have kept on functioning just fine, without any major asset fire sales or vicious-cycle deleveraging. The Fed’s liquidity provisions — chiefly its new, generous Bank Term Funding Program and renewed uptake of the discount window — are doing their job. By all indications, the Fed does not need a massive course correction right now; 25bp will do the trick.
Athey rounded out the 25bp camp, arguing that the Fed should follow the pattern set by the European Central Bank:
[The Fed] has not really got any good choices. Too much hawkishness could spook markets and bank stock/debt in particular. Too dovish could actually do the same ironically — it becomes a case of “what do they know that we don’t” . . . So it’s a narrow path. I think the ECB got it spot on, to be honest. Deliver what’s expected, soften the guidance. Talk about the potential disinflation, which could result from tightness in the banking system (tight credit = less growth = less inflation), but hammer home that you’re data dependent.
Sahm is in the pause camp. She thinks the argument that financial stresses haven’t gotten that bad misses the more important point: that the US bank failures flow directly from the Fed’s previous rate actions. In that sense, financial stability and rate policy are not separable:
Federal Reserve interest rate policy works through banks. They’re trying to raise interest rates to tighten [lending] standards so that businesses and consumers borrow less, so they buy less and invest less. Banks are where this happens . . . Regional banks failing and depositors fleeing can also affect [lending] standards and credit. It’s almost like the Fed put bank failures in its toolkit, to cool off demand . . . This could end badly. That’s why to me a pause is useful, just to take a breath and look at what’s going on.
Also a pause partisan, Sarni puts it even more simply: “What’s the downside to skipping a meeting? Let’s see how this plays out. Between SVB and Credit Suisse, the prudent thing to do is nothing. The [bank] crisis appears to be contained on the surface, but there are probably other institutions on the verge.”
On that count, Al-Hussainy has a sharp riposte:
There are two big unknowns we are feeling our way around. The first is, what is driving inflation. Wages? Well, wages are down, but realised inflation is not, especially core services ex-housing, which is going sideways. That may be the wrong metric, but it’s the one the Fed cares about. Expectations aren’t driving inflation, either. It’s something else, and if you are a policymaker, and you don’t know the driver, your only option is to keep squeezing. The other unknown is how monetary policy is affecting the economy. We’ve raised real rates, financial conditions are tighter, but penetration into the labour market is not great — quits are down and so forth, but not quickly enough to bring down inflation. It’s unfortunate, but the risk is in the [autumn] you have to go to 6 and a half per cent, and oh boy do you not want to be in that situation.
The chair and vice-chair, in predictable squish fashion, signed on with the consensus 25bp. Our view is that this market has been very quick to jump to the conclusion that rate increases are over and rate cuts are just around the corner. A pause would encourage this, and risks a big loosening of financial conditions that would tie the Fed’s hands later. The best way to manage stresses in the financial system is to get the inflation problem under control now, with help from markets, thereby maximising policy flexibility down the road.
Before the final vote, however, the UOMC adjourned hastily, when news of a stock-trading ethics scandal was leaked to the press, leaving the real open market committee to fill the void later today. We wish them luck. (Armstrong & Wu)
One good read
Some welcome news in education.
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