The Fed faces a relatively difficult decision at the FOMC meeting on 22 March. (UBS)

The free flow of credit is essential for economic activity. Anything that disrupts that flow can hurt both businesses and consumers. History demonstrates that bank failures are particularly dangerous, especially when depositors lose their funds.

It is too early to tell how much impact the recent bank failures will have on the economy. Even before these failures, there were widespread fears over the economic outlook, with consensus forecasts indicating a 60% chance of a recession starting within 12 months. Further, banks have been tightening their lending standards for quite some time. It appears inevitable that banks will tighten further, and spreads on corporate bonds have already widened significantly. Even when credit is available, businesses will face higher borrowing costs.

On the positive side, rapid action taken by the authorities should help to mitigate the damage. The decision to have the FDIC cover uninsured deposits will at least allow businesses to pay their bills. The Fed has already provided more than $300 bn in liquidity, and the new Bank Term Funding Program provides a way for banks to borrow against their bond holdings, valued at par rather than the market price.

A new path to recession

Up until now, our main fear for the economy was that consumers would slow down their spending. Households are burning through the excess savings built up during the pandemic and delinquencies are rising. If consumer spending falters, businesses will quickly pull back on hiring and that could spell the end of the recovery. The financial system troubles potentially opens a new path to recession, where business struggle to fund their operations and are forced to cut costs, leading to a big rise in layoffs and a downturn in capital expenditures. In other words, instead of a consumption-led recession, there is now also the risk of a business-led recession.

A tricky decision for the Fed

The Fed faces a relatively difficult decision at the FOMC meeting on 22 March. A few weeks ago, we would have put chances of a rate hike near 100%, with the size of the hike as the only matter for debate. Now, the Fed has to worry about a rate hike adding to the stress in the financial system. At the same time, inflation is still way above their target and the labor market looks extremely tight.

In our view, the Fed is likely to hike rates, putting more emphasis on the fight against inflation than risks in the financial system. The longer inflation stays elevated, the more likely it becomes that it will become entrenched, forcing the Fed to take more dramatic action to reestablish price stability. On the other side, in case contagion in the financial system leads to a recession, the Fed has confidence in its tools to help avoid a severe downturn. One of the advantages of higher rates is the greater scope to support the economy with big cuts when needed. If the Fed does decide to pause, we would still expect them to signal additional rate hikes in the months ahead.

Main contributor: Brian Rose, Senior US Economist

Content is a product of the Chief Investment Office (CIO).

Original report - Financial system stress adds to risks, 20 March, 2023.