The banking crisis weighs on the economy, rekindling fears of recession

The U.S. economic recovery has repeatedly defied predictions of an impending recession, withstanding supply chain backlogs, labor shortages, global strife and the fastest rising unemployment rates. interest for decades.

That resilience now faces a new test: a banking crisis that at times over the past week seemed poised to turn into a full-blown financial meltdown as oil prices plunged and investors injected cash. money in US government debt and other assets perceived as safe.

Markets calmed somewhat at the end of the week in hopes that quick action by leaders in Washington and Wall Street would limit the crisis to small and medium banks where it started.

But even if it did happen – and veterans of previous crises warned it was a big “if” – economists said the episode would inevitably impact hiring and investment as banks slashed their loans and businesses have struggled to borrow money as a result. Some forecasters said the turmoil had already made a recession more likely.

“There will be real and lasting economic impacts even if all the dust settles well,” said Jay Bryson, chief economist at Wells Fargo. “I would increase the likelihood of a recession given what happened last week.”

At a minimum, the crisis has complicated the already tricky task facing Federal Reserve officials trying to gradually slow the economy in order to bring inflation under control. This task is more urgent than ever: government data on Tuesday showed that prices continued to rise at a rapid pace in February. But now policymakers must face the risk that the Fed’s efforts to fight inflation could destabilize the financial system.

They don’t have long to weigh their options: Fed officials will hold their next regular meeting scheduled for Tuesday and Wednesday amid unusual uncertainty about what to do next. Just 10 days ago, investors were expecting the central bank to step up its interest rate hike campaign in response to stronger than expected economic data. Now Fed watchers are wondering if the meeting will end with rates unchanged.

The idea that rapidly rising interest rates could threaten financial stability is not new. In recent months, economists have often remarked that it was surprising that the Fed was able to raise rates so quickly without seriously disrupting a market that has grown accustomed to rock-bottom borrowing costs.

What was least expected is where the first crack showed up: America’s small and medium-sized banks, in theory among the most closely watched and regulated parts of the global financial system.

“I was surprised where the problem came from, but I wasn’t surprised there was a problem,” Kenneth Rogoff, a Harvard professor and leading expert on financial crises, said in an interview. In an essay in early January, he warned of the risk of “imminent financial contagion” as governments and businesses struggle to adjust to an era of higher interest rates.

He said he didn’t expect a repeat of 2008, when the collapse of the US mortgage market quickly engulfed nearly the entire global financial system. Banks around the world are better capitalized and better regulated than they were then, and the economy itself is stronger.

“Usually to have a more systemic financial crisis, it takes more than one shoe to fall,” Professor Rogoff said. “Treat higher real interest rates as a shoe, but you need another one.”

Still, he and other experts said it was alarming that such serious problems could go unnoticed for so long at Silicon Valley Bank, the midsize California institution whose failure sparked the latest turmoil. This raises questions about what other threats might be lurking, perhaps in less regulated areas of finance such as real estate or private equity.

“If we don’t get this under control, what about some of these other more obscure parts of the financial system?” said Anil Kashyap, a University of Chicago economist who studies financial crises.

Already, there are hints that the crisis may not be confined to the United States. Credit Suisse said on Thursday it would borrow up to $54 billion from the Swiss National Bank after investors dumped its shares amid fears about its financial health. The 166-year-old lender has faced a long series of scandals and missteps, and its problems are not directly related to those of Silicon Valley Bank and other US institutions. But economists said the market’s violent reaction was a sign that investors were growing increasingly worried about the stability of the system as a whole.

The turmoil in the financial world comes just as the economic recovery, at least in the United States, appears to be gaining momentum. Consumer spending, which had fallen at the end of 2022, rebounded at the start of this year. The housing market, which had collapsed in 2022 as mortgage rates rose, had shown signs of stabilizing. And despite high-profile layoffs at big tech companies, job growth has remained strong or even accelerated in recent months. In early March, forecasters raised their estimates for economic growth and reduced the risks of recession, at least this year.

‌Now many of them are backtracking. Mr Bryson, of Wells Fargo, said he now put the likelihood of a recession this year at around 65%, up from around 55% before the recent bank failures. Even Goldman Sachs, among Wall Street’s most optimistic forecasters in recent months, said on Thursday that the odds of a recession had risen ‌10 percentage points, to 35%, due to the crisis and the uncertainty that resulted.

The most immediate impact will likely be on lending. Small and medium-sized banks could tighten their lending standards and issue fewer loans, either in a voluntary effort to shore up their finances or in response to increased scrutiny from regulators. It could be a blow to residential and commercial developers, manufacturers and other businesses that rely on debt to fund their day-to-day operations.

Janet L. Yellen, the Treasury Secretary, said Thursday that the federal government is “watching very closely” the health of the banking system and credit conditions more broadly.

“A broader issue that concerns us is the possibility that if the banks are in trouble, they might be reluctant to lend,” she told members of the Senate Finance Committee. This, she added, “could make it a source of significant economic risk.”

The credit crunch is likely to be a particular challenge for small businesses, which typically do not have easy access to other sources of funding, such as the corporate debt market, and often rely on relationships with bankers who know their specific sector or local community. . Some may be able to get loans from big banks, which have so far seemed largely immune to the problems facing smaller institutions. But they will almost certainly pay more to do so, and many businesses may not be able to get credit at all, forcing them to cut back on hiring, investing and spending.

“It can be difficult to replace these small and medium banks with other sources of capital,” said Michael Feroli, chief US economist at JP Morgan. “That, in turn, could hamper growth.”

Slower growth, of course, is exactly what the Fed has been trying to achieve by raising interest rates — and tightening credit is one of the main channels through which monetary policy is supposed to work. If businesses and consumers slow down, either because borrowing is getting more expensive or because they’re nervous about the economy, that could, in theory, help the Fed get inflation under control.

But Philipp Schnabl, a New York University economist who has studied recent banking problems, said policymakers had tried to dampen the economy by stifling demand for goods and services. A financial upheaval, on the other hand, could lead to a sudden loss of access to credit. This a crunch in bank lending could also affect aggregate supply in the economy, which is difficult to address through Fed policy.

“We raised rates to affect overall demand,” he said. “Now you have this credit crunch, but it comes from financial stability issues.”

Yet the US economy retains sources of strength that could help cushion the final blows. Households as a whole have significant savings and rising incomes. Companies, after years of high profits, have relatively little debt. And despite the struggles of their smaller counterparts, the largest U.S. banks are on much stronger financial footing than they were in 2008.

“I still believe – and not just hope – that the damage to the real economy from this will be quite limited,” said Adam Posen, president of the Peterson Institute for International Economics. “I can tell a very compelling story about why it’s scary, but that should be fine.”

Alan Rappeport And Jeanna Smialek contributed report.


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