MINNEAPOLIS, MINNESOTA (March 23, 2023) – Just as investors were debating whether the Fed would raise rates by 25 basis points (bps) or 50 bps at their upcoming meeting on March 21–22, financial markets were surprised by the second largest bank failure in U.S. history. The collapse of SVB Financial Group ($215 billion in assets) on March 10 and the subsequent failure of Signature Bank ($110 billion) are the first significant indications that the rapid tightening of monetary policy over the past year is impacting business as usual in at least part of the financial sector.
Expectations for the path of Fed Funds have sharply declined since the failure of SVB. Last week, the futures market indicated an increase of 0.75% in Fed Funds by the end of summer, resulting in a peak of 5.5%. As of mid-March, a 0.25% increase is all that is expected, followed by declines of 0.75% to 1.0% by the end of the year.
The decline in interest rate expectations has occurred despite the fact that fundamental economic data has shown stronger than expected reports for inflation, consumer spending, and employment since the beginning of 2023. Until the unexpected bank failures, the stronger economic data had only solidified the Fed’s concern that price pressures may be more persistent than forecast and, consequently, expectations for interest rate actions by the Fed had moved higher.
Starting with the Consumer Price Index (CPI) report for January, all major inflation gauges showed that the rate of improvement in the inflation rate was slowing. CPI was up 0.5% enabling the year-over-year calculation to tick down from 6.5% in December to 6.4% in January. The Fed’s preferred inflation gauge, the Core Personal Consumption Expenditure Index, rose 0.6% in January, resulting in the year-over-year figure rising from 4.6% to 4.7%. Inflation has moderated since peaking last summer but remains well above the Fed’s target of 2.0%. The CPI report for February, released on March 14, will be a critical component in determining the Fed’s next interest rate move at their March 21-22 meeting.
Monthly retail sales in January advanced at the fastest rate since March 2021, up 3.0%. This strength followed two months of negative sales growth in November and December. While partly attributable to warmer than normal weather, the strength showed that the consumer still has the ability and willingness to spend at a brisk pace. There are, however, many reports of consumers becoming more price conscious and moving from top-of-the-line brands to generic brands.
The Leading Economic Indicators (LEI) index continues to portend a weakening economy with a recession highly likely. The LEI is now down to the level last seen two years ago in February 2021. Year-over-year, LEI is down 5.9% – a level that has always been associated with a recession.
The quarterly survey of Senior Loan Officers at commercial banks indicated that lending standards have been tightened to levels only seen in recessionary periods over the past 25 years. Banks are concerned about rising loan defaults, weakening collateral valuations, and general economic uncertainty. The same survey also indicated that loan demand has decreased across all major categories of loans. The SVB and Signature failures will likely keep the tightening of lending standards in place for some time.
Employment Trends and the Labor Market
As has been the case for the past year, the labor market continues to be the one leg of the economy that has yet to buckle under the tightening monetary policy of the Fed. The February employment report showed payrolls increasing by 311,000 – a strong follow up to the 504,000 gain in January. While the headline numbers indicate ongoing resiliency, a closer look at the numbers indicate some potential developing softness in the labor market. The unemployment rate increased from 3.4% to 3.6% as the number of new jobs didn’t keep up with the increase in the size of the workforce. The average weekly hours worked eased to 34.5 from a downwardly revised 34.6. Average hourly wages increased 0.2% month-over-month – the weakest monthly reading since last February – however, year-over-year wage growth still remains unacceptably high for the Fed at 4.6%.
A Deeper Look at Recent Bank Issues
Simply stated, the SVB and Signature problems were a result of depositors requesting withdrawals that exceeded the banks’ liquid assets. To generate more liquidity, the banks had to sell securities – mainly in the form of bonds – which had declined in value over the past year as interest rates increased (higher interest rates mean lower bond prices). The sale of these securities generated losses causing the banks to become insolvent, as liabilities became greater than assets.
To shore up confidence among depositors at U.S. banks, the Fed, FDIC, and the Treasury Department announced on Sunday, March 12 that all depositors at the defaulting banks would be made whole. Additionally, the Fed introduced a new lending facility to make loans of up to 12 months to banks that run into liquidity problems.
Finally, Fed commentary after the March 22 meeting will be closely scrutinized in light of the SVB and Signature bank failures. Investors will want to see if bank liquidity issues force the Fed to pause their tightening campaign earlier than expected. In Chairman Powell’s semiannual monetary policy report to Congress on March 8, he made it clear that although inflation has been moderating, “the process of getting inflation back to 2.0% has a long way to go and is likely to be bumpy.” The failure of SVB presents another challenge for the Fed to incorporate in executing their monetary policy but is not likely to cause any change in the Fed’s focus of bringing down inflation. As Powell stated, “restoring price stability will likely require that we maintain a restrictive stance of monetary policy for some time. The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”