After Bank Turmoil And Monetary Tightening, Fear Of Lurking Recession
The second fortnight of March witnessed four notable bank failures. Two of them were in USA with Silicon Valley Bank (SVB) starting the scare a week earlier in regard to the falling paper of value of bonds held as assets.
The Ides of March confirmed its failure as there were heavy withdrawals.
The assets held by SVB, which were in long time bonds had all depreciated in market value due to the anti-inflationary policy stance adopted since May 2022 after the US inflation rose to 8.6 per cent , much above the targeted rate of 2 per cent by the US Federal Reserve (the Fed) with higher interest rates.
When SVB sold some securities for cash to satisfy the demand for cash by depositors, the scare turned into reality. SVB could not meet the demand of the savers to get back their funds. It was declared insolvent. It was followed by Signature Bank. The third one was in Switzerland, Credit Suise, which had nothing to do with SVB crisis.
The fourth one was a plunge on March 25 in share prices of the largest bank, Deutsche Bank, of Germany, but a kind of reaction to all these financial crises.
Let me be clear that during the last financial crisis, there were investors and owners of systemic large banks that were bailed out … and the reforms that have been put in place mean that we’re not going to do that again. Janet Yellen US Treasury Secretary.
Excess liquidity
The reasons are not far to seek. Excess liquidity in the advanced economies, which was initiated since the 2008 Global Financial Crisis, went on unabated in several episodes, including taper tantrums of 2013 and 2014, as the US Fed had to pump in money to save banking industry to survive.
The crisis was ignited by a fall prices in the housing sector in the US and borrowers could not meet their re-payment obligations.
The US Fed purchased bad debts of banks and bonds. They increased as well as reserves of banks. According to Bloomberg, at the end of 2022, about US$7.9 trillion were uninsured deposits since the insurance coverage by the US the Federal Deposit Insurance Corporation (FDIC) is limited to deposits up to US$250,000.
Thus, only 46 per cent of deposits or $18 trillion, put in by savers in
US banks are covered by FDIC. Others are invested in money markets such as mutual funds or held in hard cash.
Excess funds have only been fanning speculative activities as the risk-free security return was at its lowest revolving around the range of zero to 25 per cent.
The targeted inflation rate by the US Fed, which is 2 per cent, was exceeded consistently each month in late 2021 but it was ignored on the grounds that they were due to transient factors.
Only in January onwards in 2022, the Fed stopped alluding to the transient factors. Inflation rose to 8.5 per cent in April soon after the Russia-Ukraine conflict became a shooting war in late February 2022. Supply chain disruptions developed leading to shortages of availability of both petroleum crude and food grains in Europe and impacting the rest of the world.
The US central bank, the Fed woke up and recognised the need for containing aggregate demand by raising the policy rate from near zero per cent to 1 per cent in May 2022. As inflation reached at 9.1 per cent in June 2022, the highest in two decades, the Fed mounted a more aggressive monetary tightening policy.
The Fed never admitted openly its mistake of delaying its “normalisation of interest rate”.
Mismanagement by SVB
It was clear SVB should have seen the writing on the wall that the socalled safe securities including government issued bonds would depreciate in market value as the market interest rate revolves around the tightening stance of the Fed. By keeping the depreciated, low market value bonds, the paper value of bonds kept as assets goes down.
They become real losses when sold in the market. The conclusion by US regulators was SVB management failed in their duties and rescue measures were ruled out.
The US Treasury Secretary Janet Yellen told the media in late March: “Let me be clear that during the last financial crisis, there were investors and owners of systemic large banks that were bailed out … and the reforms that have been put in place mean that we’re not going to do that again.”
Her focus is on “depositors and trying to meet their needs.”
In the light of growing concerns about wider financial chaos, the Fed assured that it would make funding available for eligible financial institutions by providing loans against the government bonds at original face value, of course, with a low penal interest rate.
The Senate Banking Committee unanimously agreed in its preliminary hearing in the third week of March that bank executives should be punished for their negligence .
Focus on price stability
Relieved that SVB crisis was not a major crisis, the Fed’s focus is now clearly on its objective: price stability.
On March 27, 2023, it raised its policy interest rate, known as the Fed funds rate by a quarter point to 5 per cent, the ninth consecutive rate rise and the highest rate since 2007.
A year ago, in April 2022, it was close to zero.
The Fed chair also made it clear that though he had considered pausing rate increase, as inflation was seen falling from 6.4 per cent in January to 6.0 per cent in February, it still “remains a global issue”. As the inflation in UK was 10.4 per cent in February, on March 23 the Bank of England (BOE) too raised its policy rate by a further quarter of a percentage point (25 basispoint) increase from 4 per cent to 4.25 per cent.
That was its 11th consecutive increase beginning from December 21, 2022, four months earlier than the Fed.
The European Central Bank (ECB) raised rates its interest rate to 3 per cent also in late March despite the Credit Suisse crisis, as inflation in the eurozone touched 8.5 per cent in previous month.
The rate setting committee member from Belgium was worried: “We are waiting for wage growth and core inflation to go down first, along with the headline inflation down before we can arrive at a pause”.
As inflation fell in March from February in Euro Zone (from 8.5 per cent in February to 6.9 per cent in March),in UK (10.4 per cent to in 10.1 per cent,) and USA ( 6 per cent to 5.0 per cent), the decision to lower the quantum of percentage increases by central banks in their key interest rates also went down, indicating that the cycle of interest hikes may soon come to end. On May 4, the US Fed announced a 25 basis points rise in the interest rate from 5 per cent to 5.25 per cent, which was followed European central bank (ECB) by a similar quantum of rise in to 3.25 per cent. Small increases in the interest are not a matter of comfort.
There are concerns while certain interest rate sensitive sectors such as housing have been affected by monetary tightening, inflation is still stubborn at 5 per cent. Although personal consumption price index has moderated from 5.1 per cent to 4.2 per cent, according to the Fed chair “the process of getting inflation down has a long way to go”, as it is higher than targeted 4 per cent.
Same time any more tightening would adversely affect economic activity in labour intensive sectors. There were indications of market softening. The latest data on overall economic growth was lower than the expected growth in the first quarter of 2023; it was 1.1 per cent.
The dreaded word
The Fed chair in his press meet dropped the hint. It was the dreaded word, beginning with R. “… the case of having recession, I don’t rule that out either. It is possible we might have a mild recession”. As already, Australia, India, Indonesia and Korea have paused policy rate increases, there are expectations in the US.
The latest, US Fed statement of May 4, announcing the interest rate change on May 4 does not have the sentence in March statement: “Additional (interest rate rise ) policy firming may be appropriate.”
The latest report on labour market released on May 6 revealed that unemployment fell to 3.4 per cent in April from 3.5 per cent in March; and the average wage earnings rose by 4.4 per cent in April as compared to 4.3 per cent, both on year to year basis.
The wage gowth and fall in employment rates are sustained.
The only factor which is critical is inflation. If the inflation data of April which is expected on May 11, is favourable, that is inflation is below 5 per cent of March, indicating a falling trend, we may expect the Fed interest rate policy would alter: at least pausing the rate rise
That gives a hope, the largest economy of the world is likely to end the cycle of aggressive interest rate hikes.
That will gladden the hearts of policy makers in Pacific island countries (PICs), which are dependent on tourism.
Recession in the source countries of tourism earnings would be a blow to economic recovery of PICs from the recent COVID-19 pandemic.