Economic outlook: From hiking path to turning point
When we met for our quarterly Cyclical Forum in March, the broad contours of our January Cyclical Outlook, “Strained Markets, Strong Bonds,” remained in place. That included expectations for modest recessions across developed markets (DM) as the effects of tighter monetary policy played out. We also discussed how new developments, including China’s faster reopening, Europe’s fading energy shock, and positive data revisions in the U.S. could contribute to a near-term reacceleration in real GDP growth.
Within days, however, the run on Silicon Valley Bank (SVB) in the U.S. and Credit Suisse in Europe cast a new shadow over the outlook. While these banks’ situations were unique, their problems were also symptomatic of broader fragilities in the sector stemming from tight monetary policy. The magnitude of the ultimate macroeconomic impact of these events remains uncertain, but the impetus is clearly negative.
Bearing these uncertainties in mind, we carried on our discussions and developed several conclusions regarding the six- to 12-month outlook.
Risks of sooner, deeper recession have risen
Bank failures, wider elevated volatility in bank stocks, rising cost of capital, and ongoing potential for deposit flight from more fragile small and midsize U.S. banks (SMBs) raise the prospect of a significant tightening of credit conditions, particularly in the U.S. – and therefore the risk of a sooner and deeper recession.
Monetary policy works through lags. This episode reveals that tighter financial conditions are having an increasing effect on the banking sector, and by extension on economic activity, demand, and eventually inflation.
Credit growth is likely to slow. The failures are characteristic of bigger problems at SMBs (in the case of SVB) that spilled over into the European banking sector, with Credit Suisse uniquely vulnerable given its profitability challenges and the fact that it was in the middle of a large restructuring process.
In the U.S., sizable portfolio losses relative to Common Equity Tier 1 capital, deposit outflows, and shrinking net interest margins are all pressuring SMBs, which are essential to credit growth. In 2022, SMBs accounted for around 30% of new credit to U.S. companies and households, according to the U.S. Federal Reserve Board. That source of lending is likely to slow, perhaps substantially, as SMBs shift focus toward managing liquidity amid higher funding costs and likely more stringent application of bank regulations. Larger banks that must comply with more extensive Dodd-Frank regulations are unlikely to fill the gap in smaller-scale and potentially riskier small business lending.
In Europe, the manner in which Swiss regulators orchestrated the takeover of Credit Suisse by UBS – a weekend emergency law change that erased the value of the Additional Tier 1 (AT1) bonds before the equity – raises questions about the role of AT1 instruments and their position within the capital structure that will likely raise the cost of capital for the broader banking industry. Regulators in the euro area, the U.K., and elsewhere have since stated publicly that they would not follow the Swiss regulators’ approach, but the Credit Suisse episode is a worrying precedent that could fundamentally change the European bank funding model.
Recent events will likely lead to a mild recession, in the case of the U.S., and act as yet another headwind that could very well pull Europe into recession as well. Since banks – even large, so-called national champion banks with substantial Common Equity Tier 1 capital buffers – could suffer from a crisis of confidence, we believe the risk of a deeper recession has surely gone up.
Still, there are good reasons to believe that this is not 2008. Households still have excess savings, aggregate corporate debt-to-GDP ratios appear manageable with interest-to-income ratios still low, and so far bank losses generally have emanated from rising interest rates, which reduce the value of long-duration assets, not from risky lending or credit defaults. The largest U.S. systemically important banks, which are subject to regular liquidity and capital stress tests, are still financially sound and have been the beneficiary of deposit outflows at smaller banks.
Central banks: Less tightening, but slower easing
All of this means central banks likely need to do less heavy lifting to get the same result: tighter financial conditions, which slow credit growth, demand, and eventually inflation. However, not tightening further is distinct from normalizing or even easing policy, which we still believe will require inflation falling toward central bank targets.
Previously, we’ve said that going from 8% to 4% inflation in the U.S. should be relatively easy, but going from 4% to 2% would require more time, as “stickier” categories related to wage inflation were likely to moderate more slowly and in response to weakening labor markets. We continue to expect core U.S. consumer price index (CPI) inflation to end 2023 at around 3%, still above the 2% inflation target of the U.S. Federal Reserve (Fed), while European inflation is still likely to end the year higher.
Wages, which are less flexible than prices, have generally lagged behind the price level adjustment. In past cycles, wage inflation only begins to materially decelerate one year after the start of a recession.
Last October, in our Cyclical Outlook, “Prevailing Under Pressure,” we argued that recession was likely in 2023 as a result of central banks’ aggressive moves to fight inflation. Our view was based on a historical analysis across 70 years and 14 developed economies, which suggests the economic effects of central bank tightening could become more apparent by mid-2023. According to this analysis, historically, the output gap has tended to deteriorate 1.5 to 2 years after the start of a hiking cycle, and recession and unemployment increases have tended to begin around 2 to 2.5 years out. This cycle appears to be evolving broadly in line with this historical timeline.
Recent developments likely mean that the Fed is close to being finished – or perhaps already done – hiking with its policy rate just below 5% (for more, see our recent blog post, “Fed Weighs Stubborn Inflation Against Banking System Stress”). Yet any actions to cut rates are likely to depend on how the trade-off between financial stability and inflation risks evolves. Since inflation is still likely to moderate only slowly, any actions to normalize or even ease policy are also likely to come with a lag.
Inflationary lags are likely longer in the euro area, likely keeping the European Central Bank (ECB) hiking beyond the Fed. European inflation has trailed the U.S. by around two quarters for prices and longer for wages. Higher gas prices, a weaker currency, and a less flexible labor market are likely to support a lengthier period of elevated European inflation. As a result, we believe a 3.5%–4% terminal ECB policy rate looks reasonable.
Finally, regions that are less reliant on longer-duration, fixed-rate mortgages to finance home purchases, such as Canada, New Zealand, and Australia, are less affected by the issues plaguing U.S. regional banks. The transmission of monetary policy there is working by increasing household costs through higher direct rate pass-through. Still, New Zealand and Australia’s reliance on external funding, and Canada’s strong trading ties with the U.S., raise the risk of spillovers. The Japanese economy, meanwhile, stands out as relatively insulated, and we continue to expect the Bank of Japan will move away from its yield curve control policy.
Fiscal policy and regulation: Focus on moral hazard?
Given still-high inflation, elevated government debt, and a widespread belief that the pandemic response caused the current inflationary environment, additional bank stress and rising recessionary risks are unlikely to be met with another large fiscal response, unless the economic implications are clear and severe. Policy responses are likely to be lagged and less aggressive.
This is especially true in the U.S., where political pressure could increase the stringency of the Fed’s implementation of bank regulations, particularly outside of the largest systemically important banks, limiting lending. The Fed could also tighten regulatory standards on the large regional banks where it can.
Furthermore, in the divided U.S. government, the hurdle is likely high for Congress to preemptively enact legislation (even if temporary) to restore confidence in the banking sector, such as by raising Federal Deposit Insurance Corporation (FDIC) insurance caps. Although if additional small banks should fail, we expect the FDIC and the Fed would invoke the systemic risk exception to create a program that insures the deposits of those banks.
While fiscal policy has been somewhat easier in Europe and the U.K. – in an effort to shield businesses and households from higher energy prices and to respond to the U.S. Inflation Reduction Act’s green subsidies – elevated inflation and government debt are also likely to limit any fiscal response there.