Last week, we discussed the RBA rate decision, the recent commentary from Bank of England external member Silvana Tenreyro, the RBI monetary policy decision and the US employment data - all within the context of the evolving debate over the impact of recent banking stress on credit creation, growth and monetary policy expectations.

While it remains unclear what the magnitude of the banking sector concerns will be on the real economy, it is clear that the seriousness of the issue (and the remaining opacity over federal deposit guarantee) likely leads to a new wave of bank or asset regulation, and or tighter banking discipline (internally or externally driven), and thus slower credit creation and slower growth over coming quarters. This is essentially the focal point for policymakers - predominantly in the US but essentially globally: To what extent does the change in the credit creation dynamic replace or negate the need for tighter monetary policy. Alternatively, what is the new ‘sufficiently restrictive’?

Despite the fact that the Fed delivered on the market expectations of a 25bp hike at the March 22nd FOMC (we will come back to the minutes of which shortly), suggesting that there was little immediate concern about contagion within the banking sector, the most recent commentary from Fed members has taken a notably less hawkish tone:

SF Fed Daly: “Good reason to think that the US slows without more rate moves… some time likely needed to see full impact of hikes” - Chicago Fed Goolsbee: “Fed should be careful about hiking too aggressively… tighter credit could have material impact on economy… regional banks are an important funding, credit source” - Philadelphia Fed Harker: “Promising signs that steps to slow the economy are working” - NY Fed Williams: “If inflation comes down, Fed will need to lower rates… credit impact from bank turmoil uncertain”

Indeed, even the likely solution to stemming further regional bank deposit runs (something that is actively being debated in the UK at the current juncture) - Federal deposit guarantees/insurance - likely comes at a cost to the wider banking system and likely by extension a further reduction in credit creation.

We have been clear in our view for many months now that the Fed have gone far enough, and perhaps more importantly fast enough in terms of their policy normalisation. In doing so they may well have found out that there is a different threshold or speed limit for the financial sector, than for aggregate demand, in a policy tightening sense. However, if we are right and inflation continues to fall sharply over the rest of 2023, real rates will become more restrictive and thus the level of ‘sufficiently restrictive’ may turn out to be lower than expected and even lower than the current FFR.

The sell side continues to emphasise the relative over the absolute - a concern we have raised over recent weeks. I have heard the rationale for US rate hikes to continue, on the basis that the bank deposit flight has stabilised and the adjustment to the credit space and bank lending that has occurred is equivalent to that of SVB and Signature bank balance sheets (absorbed by shadow banking). Even if this were to end up being the case and the relative impact of bank lending from now is modest (it is not clear that this is the case - and the risks are obviously increased if the Fed continues to hike the base rate), there must be an emphasis on the reduction in the absolute level of lending on the economy and not just the fact that the contraction has stabilised.

In the US, bank earnings for Q1 start this week (continuing through next week) and we would expect that increased provisions and reduced lending projections are significantly more likely than they were at the beginning of March. Largest banks expected to reveal that they have suffered deposit collapse of $521b from a year earlier according to Bloomberg (including an outflow of $61B in Q1 despite an influx of deposits from small banks during the recent concern.). Likely an important input into Fed thinking from the March meeting. In terms of the Fed decision, the Loan Officer data released in May will be a further key focus in quantifying the (ongoing?) impact of the banking stress.

This week, we have also had the Minutes from the March FOMC and the March CPI print to further shape the debate.

The minutes, while continuing to emphasise the prospect of a further rate hike - effectively asserting the primacy of the inflation mandate while at or near full employment - there was a clear acknowledgement that there is currently much greater uncertainty around its economic projections, such that the economic forecast prepared by Fed staff "included a mild recession starting later this year, with a recovery over the subsequent two years." (a downgrade from “subdued growth”) and that if banking and financial conditions were to deteriorate more quickly than anticipated, then the risks were skewed to the downside, "particularly because historical recessions related to financial market problems tend to be more severe and persistent than average recessions." Overall, the minutes indicate that the committee sees the recent turmoil as contained to a “small number of banks with poor risk-management practices and that the banking system remained sound and resilient.”

It was prominent in the minutes that policymakers had lowered their expectations for future rate hikes as a function of credit concerns, However, it is also worth noting that since the March meeting, we have had weaker: regional bank economic activity surveys (notably in services), durable goods orders, house prices, business conditions, personal spending, ISM activity (notably new orders and employment sub-indices in both manufacturing and service sectors), factory orders, average hourly earnings and perhaps most consequentially, CPI. Indeed, there is also some proprietary spending data that suggests a further slowing since mid-March (likely not yet fully captured in the data).

So, what does all of this imply for the concept of the ‘sufficiently restrictive’ policy rate in the US and thus for the May meeting. It is clear that the policy decision is now likely as much a function of the evolving credit conditions as it is the evolving economic data. While we do not expect a full-blown credit crisis, we are of the view that the policy tightening has generated the stress in the banking system (you could say that sufficiently restrictive for banks is lower than that of the real economy - or perhaps that the lags are just shorter). Either way, with inflation and growth likely slowing, and an absolute (if not a slowing relative one) impact on credit creation, we would continue to argue the case that the Fed should be done.

To paraphrase Killswitch Engage, this is the Fed’s last Serenade!