Key takeaways

  1. In March, markets expected the Federal Reserve (Fed) to hike interest rates by 0.5%, but this did not occur due to stresses in the banking system
  2. The subsequent 0.25% rate hike may be the last hike of this cycle
  3. Bank lending has a major impact on inflation, and stress on banks could lead to tighter credit conditions and slower inflation
  4. Banks could become more conservative in terms of keeping deposits in cash, which would slow economic growth and inflation
  5. The Fed is looking for a controlled way to reduce inflation, which means banks must remain stable
  6. Events will unfold over time to see if deposits stabilize across banking systems and getting loans remains difficult

There is a saying on Wall Street that the Federal Reserve keeps hiking rates until “something breaks.” Unfortunately, the failure of Silicon Valley Bank and the collapse of Credit Suisse earlier in March may be the “something” that broke. 

As recently as the second week in March, markets expected the Fed to hike by 0.5% at the March 22 meeting, with several more hikes anticipated throughout 2023. However, events in the banking system changed those plans. 

Ultimately, the Fed hiked by only 0.25% and hinted that it would pause further hikes to assess how banks react to this environment. This rate hike could very well be the last of this cycle.

Banks, lending, and inflation

Inflation remains too high for the Fed, a point Fed Chair Jerome Powell intimated several times during his press conference: “without price stability the economy does not work for anyone.” However, it is important to note that bank lending has a major impact on inflation. 

Powell said during his press conference that stress on banks “are likely to result in tighter credit conditions,” signaling a lending slowdown. If bank lending slows down, that will likely slow inflation as well.

For example, say a bank gets $1 million in new deposits. It could lend that money, perhaps to a business looking to expand. That business would subsequently hire more people, buy new equipment, etc., all of which would contribute to economic growth. But, in addition, it might also contribute to inflation.

This is the strategy banks typically employ. After all, lending is how they make their profits. However, when banks become worried about the stability of their deposits, they may choose to keep more in cash. The more banks hoard cash, the less they lend. The less they lend, the less money is available for things like expanding businesses, people taking out home mortgages, etc. That has a contractionary effect on the economy and hence should slow inflation.

Ultimately, Silicon Valley Bank’s sudden demise was caused by depositors fleeing. Executives at other banks will naturally want to avoid that same fate. That probably means mid-sized banks will do whatever they can to show their safety and security. This likely includes slowing down lending and keeping more of their deposits in cash.

There is no tradeoff between financial stability and inflation

For these reasons, as long as banks are worried about deposit stability, bank lending will be a disinflationary force. In a sense, the Fed is getting something they wanted all along. 

At the Fed’s February meeting, Chair Powell said, “Reducing inflation is likely to require a period of below-trend growth and some softening of labor market conditions.” So if banks slow down the pace of lending, it could be what finally brings about the “below-trend growth” Powell has sought all along.

That being said, the Fed wants to achieve this in a controlled manner, and having banks remain in crisis mode risks it getting out of control. This was the motivation behind the Fed’s new bank lending program, announced in conjunction with the FDIC extending deposit insurance for Silicon Valley Bank. The Fed will welcome banks becoming more conservative but will do whatever they can to keep the system operating normally. 

There’s some discussion in the financial press implying that the Fed is choosing between financial stability and fighting inflation. We don’t see it that way. 

What’s happening with banks is probably disinflationary. That reduces the need for the Fed to keep hiking rates. So there is no conflict between these goals whatsoever.

What comes next?

The Fed’s next meeting isn’t until May 3rd. That will give it time to see if deposits stabilize across the banking system and how bank behavior may have changed. 

Given its position as a bank regulator, the Fed is privy to information the rest of us don’t have. So the Fed will also talk to their business contacts to see whether getting loans has become more challenging. 

One possibility is that by May, no major banks will be in an acute state of stress, but the pace of lending will have slowed materially. If that is the case, then the Fed is not likely to hike in May or any other meeting this year. Instead, they will assume that less lending will lead to slower inflation and won’t want to exacerbate any developing economic slowdown by hiking rates further.

Another possibility is that this all blows over, and banks return to lending like they did before Silicon Valley Bank and Credit Suisse failed. If so, the Fed will probably resume hiking in May or at some subsequent meeting.

Either way, we’ll probably have to live with above-average uncertainty around the Fed’s next couple of moves while we wait to see how the current banking stress unfolds.