Clouds and Silver Linings on Bank Fears and Inflation

For a week and a half, investors have wondered how the Fed would balance competing fears of inflation and a bank panic. Now we know the answer: Hike rates by a quarter point. Any more than that, and they would get accused of being aloof to the risk of a bank run. But if they did nothing, they would give the appearance of being more worried about the banks than they have let on. When in doubt, take the non-committal third way! Markets waffled at first, flipping between a small rise and small decline, but stocks fell in the last hour of trading for the S&P 500 to finish down -1.7% on the day.^[i] We wouldn’t read into that, given post-Fed moves stem mostly from day traders’ models competing with one another, especially when many such traders likely also watched Treasury Secretary Janet Yellen’s concurrent comments to the Senate. Instead, we suggest taking advantage of a small learning opportunity in the Fed’s statement.

We refer to paragraph two, sentences one and two: “The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.” This sort of jibes with a New York Times article we read this morning titled, “How the Banking Crisis Has Had the Same Effect as a Fed Rate Increase.” The Fed seems to be trying to convince us all that it doesn’t need to continue with bigger rate hikes because banking jitters are doing its job for it.

That may come true in part. As we have noted in our coverage of the banking sector’s travails, the failure of Silicon Valley Bank and continued worries about regional banks could prompt institutions to take less risk. As long as people are talking about deposit flight—and weighing tightening regulations or reinstating reserve requirements—there is a strong case for banks to decide a dollar in reserve is better than a dollar lent. The first batch of post-Silicon Valley Bank lending data comes out on Friday and could very well show some tightening.

However, we find it a bit puzzling that this would dictate a darned thing about interest rate policy. You see, the Fed has raised the fed-funds target range from 0.0 – 0.25% to 4.75 – 5.0% since last March. That is very nearly five full percentage points. Yet in the week ending March 8, bank lending was 10.4% above the same period a year prior.^[ii] That is twice the growth rate in the first full week of March 2022, 5.2% y/y.^[iii] So while the Fed “tightened,” loan growth accelerated bigtime.

Seems to us a better way to look at this is to say banking jitters have the actual potential to do what everyone incorrectly believed Fed rate hikes would do. They could slow lending and economic growth, further tamping down the inflation rate. Rate hikes didn’t and, in our view, weren’t likely to do this. Those who argue they would presume that the fed-funds rate is the price of money. In reality, the fed-funds rate affects only the rate at which banks borrow from one another. That gave it some influence before 2008, when regulations incentivized banks to rely less on deposits for funding. Now, in a post-2008, post Dodd-Frank world, they are much more deposit-reliant. Notwithstanding potential changes over the past week, they also had far more in deposits than they needed or wanted, so they didn’t have to raise rates to keep customers put.

Despite Fed rate hikes, the average savings account rate is up from 0.06% a year ago to just 0.37% now.^[iv] Average CD rates are modestly higher than that but far below comparable maturity Treasury yields, and banks don’t get most of their funding from time deposits. So with most of their funding base costing little, they have been able to lend at higher profits as higher 10-year US Treasury yields boosted mortgage and business lending rates. Hence, much faster loan growth. That is good news from an economic standpoint, as it means rate hikes alone don’t have the power to slow growth or cause recession. We think it is a big reason why GDP closed last year at new highs.

But that continued growth also created the perception that the Fed had to do more to slow inflation. It created a good news is bad news mentality toward economic data released in February and March—stronger-than-expected results, according to most observers, meant more rate hikes and eventual pain. So to the extent that bank jitters slow the pace of rate hikes, maybe that helps sentiment. Everyone says the Fed is bailing out the banks right now. Maybe, in reality, the banks are bailing out the Fed. Maybe their heightened risk aversion will finally make the Fed look like it has some modicum of control over borrowing and that will enable everyone to move on from inflation dread. 

Yet we would be remiss not to point out a potential cloud in this silver lining. Lending is the lifeblood of economic growth. It is the source of a big chunk of investment capital. We wouldn’t be surprised to see it slow some from currently quick rates. But if it slows sharply, whether through voluntary bank deleveraging or new regulations, we could finally get the big recession everyone has been on high alert for over the past year. If that comes as a surprise to people who are cheering slower inflation, it could mean bad times for stocks. Make no mistake: We aren’t bearish now. We think a new bull market is close by, if not underway since last October’s low. We think bank fears are out of step with reality. But we also aren’t blind, and lending will deserve a close look over the period ahead.