Fynsa
The liquidity crisis at U.S. banks has complicated the Federal Reserve's task of balancing its objectives of controlling inflation and maintaining financial stability. We have argued that these two objectives are closely related, as higher monetary policy rates affect bank funding costs and loan demand, which in turn reduces bank profits and tightens financial conditions. This ultimately cools economic activity and inflation.
In addition, higher rates have contributed to financial stress by eroding banks' deposit base. U.S. depositors have been exiting banks and entering money market funds to take advantage of higher rates. Recent bank failures and the possibility of other banks evaluating strategic options (including new acquisitions by large banks) have generated distrust in the system, creating a vicious cycle of deposit outflows, liquidity needs and, ultimately, insolvency. This increases the risk of a credit crunch that could trigger recession and deflation.
For reference, $2.5 trillion in market capitalization has been wiped off the US regional bank sector, with losses exceeding 50%. In addition, the spread between deposit and money market rates in the U.S. remains considerably high, which maintains the risk of further deposit outflows and could exacerbate the crisis.
Against this backdrop, the FOMC raised interest rates by 25 bps to 5.0-5.25% at its monetary policy meeting this week, but modified its forward guidance, hinting that it could be the last hike of the cycle. Although they left open the option to tighten further if conditions warrant, they removed the reference to monetary policy needing to be "sufficiently restrictive," suggesting that rates could be at their peak.
The FOMC now sees credit tightening as a given and expects the upcoming release of the Senior Loan Officer Opinion Survey to show additional tightening. However, rate cuts are not on the committee's mind, despite bond market expectations, which anticipate cuts beginning in July and a 100 basis point tightening through January 2024, with a yield curve that remains inverted.
The concern about the impact of the credit crunch is valid. Although the current crisis is primarily a liquidity crisis, if it evolves into a solvency problem, the situation could worsen. The Fed can provide more liquidity and large banks can continue to acquire smaller banks, but if the Fed's high funds rate is the cause of the financial stress, then the solution may be to stop raising rates and start cutting them.
Inflation expectations have moderated, although they still remain above 2.0% over two years. In addition, economic data have been surprisingly downward in almost all regions. These factors also support the possibility that the Fed may consider changes to its monetary policy, adapting to changing economic and financial conditions.
In summary, the recent change in forward guidance in the FOMC statement suggests that the Fed may be nearing the end of this tightening cycle. The liquidity crisis at U.S. banks has complicated the Fed's task of balancing its objectives of controlling inflation and maintaining financial stability, and higher rates have contributed to financial stress in the banking sector. Therefore, it is critical to monitor the situation closely and be prepared for possible changes in U.S. monetary policy.
