For all the talk about the Federal Reserve’s next move, the banking sector has quietly been doing the central bank’s work for it.
As benchmark interest rates rose over the past year and the economic outlook grew murkier, banks gradually started tightening their lending standards. Those efforts have intensified in recent months following the collapse of Silicon Valley Bank and Signature Bank in March. While banks are still lending, the pace of loan growth is deteriorating, Torsten Slok, chief economist at
Apollo Global Management
observed in a recent note to clients.
That tightening of lending standards—coupled with tighter financial conditions thanks to rate hikes—has effectively added 1.5 percentage points to the federal-funds rate, Slok wrote. That could spell trouble for the economy, as the effects of the Fed’s rate hikes aren’t felt immediately in the economy. That means there are worries the Fed will continue to raise rates aggressively, without giving time for previous hikes to do their work.
The “lagged-behind effects of Fed hikes combined with tighter credit conditions will create a sharper slowdown in the economy,” Slok wrote.
To be sure, the Fed is aware of the effect that its policies, as well as the recent turmoil in the banking sector, is having on the economy.
Developments in the U.S. banking sector “are contributing to tighter credit conditions and are likely to weigh on economic growth, hiring and inflation,” Fed Chair Jerome Powell said last week. “As a result, our policy rate may not need to rise as much as it would have otherwise to achieve our goals,” he added.
Wall Street is hoping this sentiment will lead the Fed to pause future rate increases as it allows the effects of previous rate hikes and tighter credit conditions to be felt in the economy. Minutes released Wednesday from the Fed’s May 2-3 meeting—in which it lifted interest rates by 25 basis points to a range of 5-5.25%—also showed that policymakers were feeling “less certain” about “the extent to which additional increases in the target range may be appropriate.”
Even if the Fed were to pause rate increases, banks still face headwinds. The failure of Silicon Valley Bank in March and First Republic in May raised the funding costs for banks “permanently,” Slok wrote. Bank bond spreads have widened by as much as 150 basis points since January, with much of the jump occurring over the last two months, he noted. Also, with rates rising and deposits fleeing in search of higher yields in money markets and other assets, banks are feeling pressure to pay their depositors more.
Normally banks would like to offset these elevated funding costs by issuing more loans that charge higher interest rates to borrowers. But with banks getting more strict on the lending side, their net interest margin is likely to contract.
While fears of more bank collapses are generally in the rearview mirror, it’s still a tough time to be a bank investor.
Write to Carleton English at [email protected]