The Fed’s Unwanted Ally in Trying to Tame Inflation: The Credit Crisis

At the same time, some economists are concerned that the downturn could turn out to be so severe that it causes the economy to slide into a painful recession.

On Wednesday, the Fed raised its benchmark interest rate for the ninth time in just over a year. Central bank policymakers are grappling with a persistently high rate of inflation that has confused American households and heightened uncertainty in the economy. At about 6%, US inflation remains well below last year’s peak, but remains well above the Fed’s annual target of 2%.

But the Fed also signaled that it may be nearing the end of rate hikes. In part, this is because a decline in bank lending could help the central bank achieve its overall goal of slowing the economy and taming inflation.

At a press conference on Wednesday after the Fed’s announcement, Chairman Jerome Powell suggested that tighter lending standards, resulting in the withdrawal of loans, could have the same dampening effect on inflation as a Fed hike could.

“Not everything has to come from rate hikes,” Powell said. “It could come from tighter credit conditions.”

Similarly, after the European Central Bank raised its own benchmark interest rate by a significant half a percentage point last week, its president, Christine Lagarde, said the ECB was not locking into a pre-set plan for rate hikes and that future rate decisions would be made at a meeting- to-meet basis.

Anxiety around the European banking system “may have an impact on demand and may actually do some of the work that might otherwise be done by monetary policy,” Lagarde said just days after two major US banks collapsed and Swiss banking giant Credit Suisse called for a bailout of its rival UBS.

Indeed, if Europe were to experience a credit crunch, analysts say, last week’s ECB rate hike could be the last for a while.

ECB officials have said their banks are “robust” and have strong enough capital buffers and cash to cover any deposit withdrawals they face. European regulators have used international standards, requiring more cash on hand. In contrast, US regulators exempted all but the very largest US banks. Silicon Valley was one of those banks.

And when loans are more expensive and harder to qualify for, consumers, who drive most of the US economy’s growth, are less likely to spend.

Gregory Daco, chief economist at consultancy EY-Parthenon, said he thinks a significant credit crunch would have “a little bit more” of an economic impact than the rate hike the Fed announced on Wednesday.

Edward Yardeni, an independent economist, said he would estimate the impact to be even greater – equivalent to a full percentage point increase from the Fed.

Inflation could slow as a result, helping the central bank achieve its long-term goal. But the burden on economic growth can also be significant. Most economists have said they expect a recession in the US by the second half of this year. The main question is how serious it can be.

Signs of a possible credit crunch in the US had begun to emerge even before the collapse of Silicon Valley Bank on March 10, raising concerns about the stability of the financial system. Faced with rising interest rates and a worsening economic outlook, banks were already becoming more cautious in approving loans to businesses in late 2022, according to a Fed survey of bank lending officials.

And banks’ “commercial and industrial” loans to businesses fell last month for the first time since September 2021, according to the Fed.

Since then, the stress on the banks has only grown. Silicon Valley Bank, which had been the nation’s 16th largest bank, failed after racking up huge losses on its bond portfolio that prompted worried depositors to withdraw their money. Two days later, regulators shut down New York-based Signature Bank.

The Federal Deposit Insurance Corporation, which insures bank deposits up to $250,000, said banks had $620 billion in paper losses in their investment portfolios at the end of last year. This was largely because higher interest rates had greatly reduced the value of their holdings in the bond market.

Powell declared on Wednesday that the banking system is “sound” and “resilient”. Still, fears remain that more depositors will pull their money out of all but the biggest US banks, increasing pressure on financial institutions to lend less and save cash to meet withdrawals.

Banks with less than $250 billion in assets account for about half of all lending to businesses and consumers and two-thirds of mortgage lending, noted Mark Zandi, chief economist at Moody’s Analytics.

“Credit is really the grease that lubricates the American economy and allows it to function and grow at a steady pace,” Daco said. “Without credit — or with lower credit growth — we’re likely to see companies be more hesitant in terms of investment decisions, in terms of hiring decisions.”

A tightening of bank credit, he said, “significantly increases the risk of a recession.” ____

AP Business Writer David McHugh in Frankfurt and AP Economics Writer Christopher Rugaber in Washington contributed to this report.