Fynsa
The liquidity crisis among U.S. banks has complicated the Federal Reserve’s task of balancing its goals of controlling inflation and maintaining financial stability. We have argued that these two objectives are closely linked, as higher monetary policy rates affect bank funding costs and demand for loans, which in turn reduces bank profits and tightens financial conditions. This ultimately slows economic activity and inflation.
In addition, higher interest rates have contributed to financial stress by eroding banks’ deposit bases. U.S. depositors have been moving their money out of banks and into money market funds to take advantage of higher rates. Recent bank failures and the possibility that other banks may be evaluating strategic options (including new acquisitions by large banks) have generated mistrust 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 a recession and deflation.
As a point of reference, the U.S. regional banking sector has seen 2.5 trillion in market capitalization wiped out, with losses exceeding 50%. Furthermore, the spread between deposit rates and money market rates in the U.S. remains considerably wide, which keeps the risk of further deposit outflows alive and could exacerbate the crisis.
In this context, the FOMC raised interest rates by 25 basis points to 5.0–5.25% at its monetary policy meeting this week, but revised its forward guidance, suggesting that this could be the last rate hike of the cycle. Although they left open the possibility of further tightening if conditions warrant it, they removed the reference to monetary policy needing to be “sufficiently restrictive,” suggesting that rates may have peaked.
The FOMC now views the credit tightening as a fait accompli and expects the next Senior Loan Officer Opinion Survey to show further tightening. However, rate cuts are not on the committee’s radar, despite expectations in the bond market, which anticipates cuts beginning in July and a 100-basis-point adjustment through January 2024, with the yield curve remaining inverted.
Concerns about the impact of the credit crunch are 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 ones, but if the Fed’s high funds rate is the cause of the financial stress, then the solution might be to halt rate hikes and begin cutting rates.
Inflation expectations have moderated, although they still remain above 2.0% over a two-year horizon. In addition, economic data have been coming in lower than expected in almost all regions. These factors also support the possibility that the Fed will consider changes to its monetary policy, adapting to changing economic and financial conditions.
In summary, the recent shift in the forward guidance of the FOMC statement suggests that the Federal Reserve may be nearing the end of this tightening cycle. The liquidity crisis among U.S. banks has complicated the Federal Reserve’s task of balancing its goals of controlling inflation and maintaining financial stability, and higher interest rates have contributed to financial stress in the banking sector. Therefore, it is essential to closely monitor the situation and be prepared for possible changes in U.S. monetary policy.
