Banks likely to lend less money in fallout of bank failures

WASHINGTON (TND) — The volatility and reaction from the bank sector after the collapse of two U.S. banks could help the Federal Reserve cool the economy and help get inflation back to its target after it has stayed stubbornly high for nearly two years.

The Fed announced a 25-basis point increase to its benchmark interest rate at the conclusion of its March meeting last week, the smallest bump since being lifted from near-zero one year ago.

Fed chairman Jerome Powell said the central bank had considered pausing rates after the failures of Silicon Valley Bank and Signature Bank added uncertainty to the economic outlook as the federal government tried to avoid a contagion effect that would lead to more bank runs and collapses.

“That 25-basis point interest rate hike had to happen,” said Farrokh Langdana, professor of finance and economics at Rutgers Business School. “What happens with inflation is if the Fed had not raised interest rates the signal would have been ‘OK, the soft landing is done. The Fed’s not going to tap the brakes anymore.’ We would have been off to the races, people would be like ‘Alright, time to go revenge travel, revenge eating out.’ All kinds of consumption spending would happen.”

Prior to the bank failures, investors were expecting the Fed to move forward with a 50-basis point increase at the March meeting after a hot jobs report to start the year that was followed by another month of strong employment data in February. Inflation also remained around 6%, which bolstered Powell’s argument that further tightening would be needed.

But the uncertainty and volatility in the banking system pushed the Fed to go forward with a smaller increase and could also help cool the economy. Fed officials are expecting banks to be more cautious with lending to protect themselves, which Powell said could act as its own interest rate increase.

“We’re looking at what’s happening among the banks and asking, is there going to be some tightening in credit conditions?” Powell said. “In a way, that substitutes for rate hikes.”

Federal Open Market Committee members updated their projects for the economy in reaction to the anticipated decline in lending, moving expected growth down to 0.4% this year and 1.2% next year down from 0.5% and 1.6% at their December meeting. However, Powell said it is impossible to gauge exactly how that will affect the broader economy.

Consumers will see the tightened lending conditions in the form of high interest rates for things like mortgages, auto loans and credit cards. The effects are similar to what the Fed is trying to achieve through rate increases, which is to cool the economy by making it more expensive to borrow money.

“The events of the last two weeks are likely to result in some tightening credit conditions for households and businesses and thereby weigh on demand on the labor market and on inflation,” Powell said. “Such a tightening in financial conditions would work in the same direction as rate tightening. In principle as a matter of fact, you can think of it as being the equivalent of a rate hike or perhaps more than that, of course it's not possible to make that assessment today with any precision whatsoever.”

The Fed is trying to walk a tight line between cooling inflation while keeping the financial system as stable as possible. Higher interest rates also add stress on the financial sector, which can cause more economic damage.

There have been some signs of Americans moving their money outside of smaller and mid-size banks to larger institutions, but an all-out response from the federal government and a generous lending program to shore up liquidity for any struggling banks has so far held off a broader crisis.

In a Yahoo News/YouGov poll released last week, about 12% of Americans said they had taken money out because of SVB’s collapse and 18% said they are considering it. However, 55% of people said they are confident the banking system is safe.

In addition to creating a lending program for struggling banks, the federal government has also guaranteed all deposits at the failed banks even if they went beyond the insured limit of $250,000. It has also sparked conversations in Congress about potentially raising the limit beyond its current figure.

“The banks have been bailed out a lot since the housing crisis. I don't lie awake at night worrying about them,” Langdana said. “They have had a really good run, they've been bailed out for really bad behavior since 2008.”