In a State of Limbo
Limbo: in a state of uncertainty, up in the air, in abeyance, betwixt and between. (Collins Dictionary). Stuck between heaven and hell (Theology)
The US economy is in a state of limbo, hovering uneasily between recovery and recession. One could say the same about US inflation: it’s coming down but it is still far above target: in theological terms it is somewhere between heaven and hell and looks like staying there for some time.
And then there are the regional banks. A few have already failed which can be plausibly put down to poor management – the exception rather than the rule - and so not a foretaste of something more systemic. Except that behind the issue of (poorly managed) interest rate risk there looms the much larger shadow of commercial real estate lending. Small and medium-size banks are by far the largest funders of offices, malls, and business parks, and commercial real estate loans are by far the largest share of regional bank assets.
The banking system as a whole is being slowly defunded as depositors seeks better returns and greater safety elsewhere – in money market funds mostly but for some that means gold or crypto currencies. This in itself contributes to a progressive tightening of credit conditions and reduction in credit availability. But in the wake of the pandemic there is a more structural problem with office demand, or for that matter second tier commercial real estate of all kinds. The further that interest rates rise, the bigger the eventual problems and potential losses for owners or lenders are likely to be. These are the sort of problems that would require patience and time to work themselves out (by repurposing or refinancing buildings that can no longer service their debt) even if interest rates merely stayed where they were. If the Fed keeps pressing on with its inflation fight regardless depositors have even more reason to be wary, more reason to seek safer alternatives to smaller banks, even ones whose interest risk management is exemplary. So arguably the regional banks are also in limbo – waiting, uncertain, stuck and fearful of future outflows.
So, however much Fed officials may protest they too are in a state of limbo: it is risky for them to simply go on raising rates (without limit) until inflation come down to target, but equally no time to be cutting them either. As we outline below this is not just a temporary difficultly, it is just where we are, like it or not. And of course OPEC’s decision to cut oil output still further makes the policy trade-offs even less attractive than before …
As recently as Powell's testimony at the Humphry-Hawkins senate committee hearing, the Fed was making clear that it was not yet satisfied with the progress made on inflation and that it still had 'work to do'.
The quarterly annualised rate of inflation of 'Core Services' (CPI Services less shelter and energy) had fallen from a peak of 9.2% to 3.6% between June and December 2022. Unfortunately this has started to tick up again, reaching 4.5% in February. Likewise, the PMI Services Survey of output prices has ticked up from 55.2 to 57.1 in March. (Figure 1). The year on year chart of core services (Figure 2) highlights the perception at the Fed that although some progress has been made, we are still far off levels consistent with 2% inflation.
The labour market has also shown encouraging signs recently, with the Job Openings report yesterday showing further declines in February, down from 10.6 million to 9.9 million on top of downward revisions for January. Meanwhile, the net job gains (new hires minus separations) were 343k in February - slightly below the 12 month average of 385k monthly new jobs) and 1.1 million over the last 3 months of data.
However with the early signs of cooling and incessant rate hiking from the Fed, why are we not heading into recession? The reason is that consumer incomes are healthy and rising. Figure 4 shows the log levels of real discretionary income versus real discretionary spending (discretionary means after costs of essentials: housing, energy and food).
Since the peak in oil prices last summer, real discretionary income has been rising (up 2.5% since June 2022). Despite the fluctuations in available income, consumers have stayed remarkably consistent to trend when it comes to spending. The surge in the cost of living as the US came out of lockdown was financed in large part by consumers drawing down their savings. Since June, as the cost of living cooled and wages caught up, consumers have taken the chance to rebuild some of those savings, which has also helped to cool inflation.
Unfortunately, over the course of just a few weeks this prospect has been dampened by a systemic shock to the banking system and a surprise cut in oil production in an already tight oil market. Both of which happening at the same time are making the Fed's job much more difficult.
The charts below illustrate the scale of stress that the banking sector has come under recently. Figure 5 shows a proxy for emergency loans that the Fed made to banks by subtracting Securities held out right from total assets. This jumped by $400bn to $800bn in two weeks.
Meanwhile, cash moving into money markets spiked by about $250bn before decelerating slightly into last week as shown in red in Figure 6. Figure 7 shows the net inflows into money markets versus the liquidity injection into commercial banks by the Fed. As expected, the Fed did provide more liquidity than was immediately necessary (by about $80bn), although these estimates are crude and reflect the overall commercial banking sector. The issue is that there are particular segments and individual banks that have seen large outflows and may be harder to rescue. Many are heavily exposed to the declining commercial real estate sector with some areas such as San Francisco and Huston recently seeing a large increase in the vacancy rate for office space.
The bottom line is that either the Fed accepts that policy too should be in limbo, and tries to buy time for the banking sector by pausing the hiking cycle, or it hopes the banking sector proves to be resilient enough and take Bullard's advice to continue charging ahead with rate hikes to 'protect' its credibility. The market is already telling us us that if the Fed chooses the latter course they will not it see it as a sustainable policy - and more likley to crash the banking system or the economy or both than cure the inflation problem in an orderly way. The FOMC has a big choice to make at it's next meeting.