May 02, 2023
Policymakers have little room left for mistakes in tackling inflation and the fallout of banking turmoil
May 2, 2023
The writer is managing director and head of economic research for global fixed income and macro at Citadel
In early March, markets were suddenly blinded by strong flashbacks of the 2007-08 financial crisis. Over a couple of weeks, the US government invoked its systemic exception to guarantee the deposits of the failing Silicon Valley Bank, while the Swiss government bailed out Credit Suisse, a globally systemic, important bank.
Suddenly, bank deposits were no longer considered safe and banks’ holdings of US Treasuries were deemed risky assets when marked to market. The world appeared to have turned upside down.
And yet, a month later, global equity markets, as measured by the MSCI World index, are back near their highs of the year; the VIX index, a proxy for risk aversion in equity markets, is at the lowest level since early 2022; and both the Federal Reserve and the European Central Bank have signalled that they are likely to raise rates again when they next meet.
Even the well-anticipated closure of First Republic, the second-biggest bank failure in the US, has not rattled investors. Are markets and policymakers being complacent, and is the worst yet to come?
The positive market behaviour since these events suggests that the global economy remains robust and the policy reaction has been both aggressive and well crafted. Ample risks remain, no question, but the outlook is less dire than many feared only a month ago.
The soundness of private-sector balance sheets, coupled with the steady fiscal support stemming from the growing appetite for industrial policy, have put the economy in a better position to cope with rising interest rates. At the same time, robust labour markets, lower energy prices, the still ongoing recovery in services consumption and the post-Covid reopening in China are providing support to the global economy.
The aggressive policy response followed the so-called separation principle outlining how central banks should tackle the twin objectives of price stability and financial stability with two instruments — interest rates and liquidity. However, the non-linear nature of a potential credit crunch means that prudent risk management will probably overcompensate in seeking to limit the impact on the economy by raising interest rates less. As a result, it is likely that overall financial conditions are now easier than they were prior to the SVB crisis.
The rapid policy response is testimony to the improvements in crisis management frameworks over the past decade, both in terms of intellectual consensus and policy infrastructure. Unlike in 2008, there have been no more lengthy debates over moral hazard, modalities of liquidity support or adequacy of banking rescues, no more uncertainty about central bank liquidity provision or the stability of dollar global liquidity.
Over just a few days, the US government invoked the systemic exception to guarantee deposits at SVB and deployed public funds to allow the Fed’s provision of liquidity against collateral marked at face value. This was complemented by central banks increasing the frequency of their dollar swap facilities. What in 2008 may have taken weeks or months to debate, design and deploy was done in a weekend.
Risks remain though, and lessons will have to be learned. Inflation is still too high and sticky, and monetary policy will have to remain restrictive for an extended period to reduce inflation as the economy cools down. US banks, facing rapidly increasing funding costs, will continue to lend but may raise lending rates to protect their income, amplifying the effect of monetary policy.
However, sound US corporate balance sheets, with still ample available cash to fund investment projects, suggests the headwind from the banking turmoil may be gradual and limited. The narrow path to a soft landing is still visible as past price shocks will continue to dissipate, allowing monetary policy to eventually be eased. However, the room for policy mistakes such as a debt ceiling crisis has shrunk.
The policy responses to SVB, First Republic and Credit Suisse have implications for the design of banking supervision and regulation. It is risky to rely on deposits as disciplinary instruments, and policy must be redesigned to include smarter capital buffers and more effective supervision so that deposits are better protected in crisis times.
Credit Suisse was bailed out, rather than liquidated as global supervisors may have preferred, after a decade of working on complex resolution frameworks. Beyond geopolitical considerations and the desire to preserve national champions, it seems clear that when a fast policy reaction is needed, as it is the case with globally systemic banks, the current resolution frameworks are not yet up to the task.
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