The economy continued to grow in March, with inflation still unacceptably high, and the Federal Reserve tightening further. But the economic news was dwarfed by banking system troubles and the takeovers of Silicon Valley Bank (SVB), Signature Bank, and Credit Suisse. Financial markets were roiled by the banking problems, and there is still much uncertainty with regard to the health of the banking system, regulatory policy, and central bank responses.
The job market remained hot in February, with nonfarm payrolls rising by 311,000 (after surging by 504,000 in the prior month). The U-3 unemployment rate moved higher to (a still very low) 3.6 percent, but this increase derived primarily from a jump in the size of the labor force – a positive reason for the rise in the U-3 rate as new labor force entrants typically don’t get jobs immediately. Moreover, weekly unemployment claims have been locked in around a historically low 195,000 into mid-March. Despite layoff announcements, there are no signs of a fundamental slowdown here.
A solid job market is the most important factor for consumer spending. Despite this, February retail sales dipped by 0.4 percent, although this modest decline came after a surge of 3.2 percent in the prior month. Additionally, core retail sales (also known as retail control, which is the total less gasoline, auto, and building supplies) rose by 0.5 percent, indicating that consumers didn’t pull back completely.
Business activity was mixed. The manufacturing sector continues to be in retreat according to the Institute for Supply Management (ISM) survey. This survey has been below 50 (indicating contraction) for four consecutive months through February. Other survey data confirm the weakness in manufacturing. But the service sector continues to expand, with the ISM survey for services at 55.1 for February – about the average for the past year (excepting what appears to be an anomalous drop below 50 for December). The NFIB Small Business Optimism Index edged higher for February, but the trend in this survey has been roughly flat for nearly a year at relatively low levels.
Generally lower mortgage rates in February helped support housing activity, with new home sales, existing home sales, and housing starts all up for the month. Mortgage rates jumped at the end of February, however, and moved higher over the first half of March before dropping again in response to lower Treasury yields following the banking sector problems. On average, mortgage rates were about 30 basis points (bps) higher in March than in February, and higher rates are likely to put some downward pressure on housing demand. But there are a couple of reasons why the housing sector is unlikely to drop sharply from here (absent a spike in mortgage rates and/or the economy falling into recession). First, there continues to be solid demographic demand for housing units, with household formations outpacing housing starts. Second, the number of housing units for sale, while above year-ago levels, is still historically low.
Consumer surveys were down for their most recent readings. The University of Michigan’s Consumer Sentiment Index fell over the first half of March to its lowest level of the year (although still above last year’s low levels). The Conference Board’s Consumer Confidence Index slipped in February and it was modestly below the average for last year.
The two indicators that we think give the best guidance on economic growth continue to suggest that the current expansion will end soon. The Conference Board’s Index of Leading Economic Indicators (LEI) continues to decline (for 11 consecutive months) and February’s 12-month change of -6.5 percent is at depressed levels that have always preceded recessions. Additionally, the yield curve continues to be inverted, with long-term rates above short-term rates. When this inversion is both sustained enough and deep enough, recessions almost always follow – and both of these qualifications have probably been met. The most recent data on the spread between rates on 10-year and 3-month Treasury securities (through March 24), show the largest inversion since September 1981. But these two measures are leading indicators of recession, not measures of a current downturn. Indeed, the Atlanta Fed’s GDPNow measure shows first quarter real growth at 3.2 percent – well above the estimated longer-term trend of around 1.5-2.0 percent. While this estimate will likely change as more complete data are released for the quarter, it appears that first quarter growth was solid. While a recession may yet occur this year, it certainly isn’t happening now.
Inflation and the Federal Reserve
Inflation continued to be elevated in February and, importantly, remained well above the Fed’s long-term goal of 2.0 percent. The Consumer Price Index (CPI) rose by 0.4 percent for February, a tick down from January, with this smaller gain allowing the 12-month trend rate to decline to 6.0 percent – the slowest in 17 months. The news was not as good for the core CPI (removing the volatile food and energy components), as it increased by 0.5 percent for the month, a tick above the January read, while its trend rate was little changed at 5.5 percent. Fed Chair Jay Powell recently noted the importance of services less shelter as perhaps the best measure of underlying price pressures. This measure of underlying inflation has been extremely volatile on a monthly basis for a while, with a slowdown to 0.1 percent for February. Even with this slower monthly gain, the trend rate moved lower, but only to 6.9 percent – obviously well above the Fed’s 2.0 percent goal. (Note that the Fed prefers to look at the broader price index for personal consumption expenditures, which has been a bit cooler than the CPI recently, but it is also well above the 2.0 percent goal.) The PCE price index for February will not be available until after this report is finished.
The combination of underlying inflation continuing to run above its goal and solid economic growth were the main reasons that the Fed tightened monetary policy at the March FOMC meeting, despite banking sector problems (see below). While the Fed slowed the pace of tightening with only a 25 bps hike in the target range for the federal funds rate, updated projections by the FOMC members showed no change in their expectations for the end-of-year rate. The fed funds target range is now up to 4.75-5.00 percent, the highest since September 2007. And with the median projection for fed funds at the end of this year remaining at 5.1 percent, one more tightening move is on the table. Importantly, the Fed sees no easing of monetary policy for this year, an expectation at significant odds with the expectations of financial markets. Data from the CME group show that the median market expectation for the fed funds target range after the December FOMC meeting is 2.75-3.00 percent. Moreover, the distribution of expectations shows a zero percent probability of anything above 4.00-4.25 percent. One group or the other is going to be significantly wrong.
While we hate to “bury the lede” the most important events over the month were in financial markets. An exodus of deposits at SVB (as well as Signature Bank in the US and Credit Suisse in Switzerland) that threatened to become a larger run on banks led the Fed and the Swiss banking authority to take over those firms, arranging an orderly transfer of assets and liabilities to other banks (with Credit Suisse being subsumed within UBS). There were a number of factors that created the problems at these institutions, especially at SVB. These included a lack of risk management (and perhaps necessary oversight), a reliance on a high share of deposits above the FDIC’s $250,000 insurance limit, and the magnitude and rapidity of the Fed’s rate hikes (even if appropriate as an inflation management policy). The Fed tried to find a buyer for SVB; and when that failed, the bank was closed down. (Note, however, that as this report was being written, First Citizens Bank had agreed to purchase the remains of SVB.) Moreover, with powers given after the Great Financial Crisis for systemically important institutions, the banking regulators in the US announced that in this case the deposit insurance limit would be ignored. Additionally, the Fed announced the creation of a Bank Term Funding Program (BTFP). The BTFP offers loans of up to a year in length to eligible depository institutions using US Treasuries, US agency securities, and US agency mortgage-backed securities as collateral. Importantly, these securities would be valued at par, even though the current market values for the vast bulk of these securities have declined as interest rates have risen. Banking regulators hope that the combination of insuring deposits above the $250,000 limit in this case and the BTFP for all eligible institutions will stem any serious deposit runs and allow banks to meet any demand for deposits (at least temporarily).
There are still many unanswered questions about the banking system and regulatory policy. Are there other banks in a condition similar to SVB? Certainly, larger banks have robust risk management and have significant oversight by regulators. What about smaller and mid-sized banks? Hopefully they have been run better than SVB was, and it is likely that most of them have been. But bank balance sheets have been hit by the sharp runup in yields (and the resulting drop in market values) on the securities that make up most of their assets. If banks can keep these assets in the “held to maturity” category, there should be few problems. But if significant deposit runs occur at other banks, they may be forced to sell those securities and recognize the drop in value on their balance sheets. The BTFP should reduce the risk of this occurring, however. There are ongoing questions about the $250,000 deposit insurance limit. Will it be raised, and if so, could it cover all deposits? This step would reduce (and perhaps eliminate) the risk of deposit runs, but at the significant cost of increasing moral hazard. It’s unclear the extent to which this episode will cause banks to become more cautious with lending decisions. The Fed’s first quarter Senior Loan Officer Opinion Survey already showed that the net percentage of banks tightening credit standards for commercial and industrial (C&I) loans had increased substantially to levels consistent with levels that occurred in the past four recessions. The slowing of bank lending is one of the channels by which tighter monetary policy works to slow aggregate demand growth (and thus inflation), but there is a risk that a further pullback in credit extension by banks in response to this episode could increase the odds of a recession later this year.
In the meantime, financial market volatility and uncertainty have increased sharply. Since the news on SVP problems surfaced on March 9, yields on Treasury securities, which have no credit risk, have plummeted in response to a flight to safety. For example, the 10-year Treasury note yield fell from 3.98 percent on March 8 to 3.38 percent on March 24 (the lowest level since mid-January and almost a full percentage point below their cyclical high of last October). The CBOE Volatility Index (the VIX) jumped from 19.11 just before this episode began, to 26.52 on the following Monday – not a big increase as these things go, but directionally it shows a rise in uncertainty. The S&P 500 Stock Index has seen substantial day-to-day and intra-day moves, but it has declined only by about 0.5 percent since the news about SVB broke and it is essentially unchanged from where it was at the end of February.
If the recent moves by regulators have calmed markets and depositors, then economic fundamentals should once again become the primary determinants of broad financial market prices.
David W. Berson, Ph.D.
Chief US Economist
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