Our hosts discuss comparisons with the global financial crisis, the negative economic spillovers of banking worries into the economy, and how all this effects the decision making of the Fed and other central banks.


Paul Diggle 00:21

Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle chief economist at Aberdeen, I'm joined by Luke Bartholomew, Senior Economist and co-host of the podcast. And at the end of the previous show, we said, we're going to talk about the UK economy today. But actually, we're going to park that until the next episode. And instead, we're going to focus on a huge driver of macro markets at the moment, which is events in the US and European banking sectors. So, we're going to think through how they might be changing the macroeconomic outlook. Is this a rerun of the global financial crisis or not? What does it mean for economic growth and a possible recession? And how is monetary policy going to react to all this? So, a lot to talk about. Let's get right into it. Luke, why don't you kick us off then with the million or perhaps its a billion or a trillion dollar question? Do we stand on the precipice of a systemic financial crisis or are we looking at something quite different to the GFC?

Luke Bartholomew 01:36

Well, it, Paul, I mean that's a question that's clearly fraught with a lot of risks for any forecaster, and don't want to be too much of a hostage to fortune here. But our very best assessment as things currently stand is that this is not a systemic crisis in the sense of posing an existential risk to the entire financial system. And I would be quite cautious to draw comparisons to 2008, for several reasons. First, I think we just need to be clear about how big a crisis 2008 was, it was world historic, as it were, in its scope in the threat that it presented to the financial system, and the economy. These are the kinds of things that just, thankfully, don't come around too often. And there can be a lot of bad things that happen, a lot of crises even that don't get anything like, to the extent the scope of the 2008 crisis. So that's the first reason I would be a little bit cautious about drawing comparisons to back then. And the second is, our best assessment is that we're just not set up for that kind of crisis, given a variety of differences between the economy and the banking system now. So banks are just much better capitalised than they were back in 2008, they're better regulated, they've been through a variety of stress tests, the liquidity position on the whole is very strong, we have a much better understanding of the financial system, at least we think we do in terms of the financial plumbing, and the way that the shadow banking system works in a way that regulators and policymakers didn't really have an understanding back in 2008. And that's one of the reasons we got into so much trouble. The private sector as a whole has a much stronger balance sheet now than in 2008. And the kind of assets that the banks are exposed about or worried about, at the moment, you know, their exposure to Treasury bonds, I mean, it's a completely different beast, to the exposure to the residential real estate market - the problem back in 2008. There's a very vicious feedback loop that can exist between the banking and real estate nexus that when one goes down, it has this nasty multiplier effect that brings the other down, that isn't really there for the Treasury market. And so, I think, a better framing for the issues we've seen at Silicon Valley Bank, and indeed Credit Suisse is that they were idiosyncratic issues that reflected particular risks or concerns about those businesses, rather than the first of many dominoes that as they fall will bring others down with them. But there are two big caveats to that. First, look at the start of any crisis, they tend to look like idiosyncratic risks. And then before long, it turns out that no, actually, it's system wide. So there's only so much comfort that one should take from the fact that these are idiosyncratic or so it seems. And the second is that ultimately, this whole thing does rest on confidence. The entire business model of banks rests on confidence and the financial system as a whole rest on confidence, and if that's lost if a panic dynamic develops, then you know, regardless of some of those macro fundamentals, banking fundamentals that I've pointed to, then really all bets are off in terms of what can happen in that situation.

Paul Diggle 05:16

I think you've covered yourself with sufficient caveats, Luke, one hopes. I think another crucial point to make is that the absence of systemic risks isn't the same thing as the absence of continued stresses in the banking sector, and indeed, negative spillover effects to the economy. So drawing a distinction between systemic risks and negative spillovers is an important one. And indeed, I think there are going to be considerable amounts of the latter. And just thinking through some of those channels - so one channel where financial sector volatility would usually be expected to feed into the macro economy is through financial conditions, you know this broad constellation of asset prices, interest rates that we think in the end influences business and consumer behaviour and therefore aggregate economic activity. And actually, on the whole, these financial conditions indices, because we try and quantify this sort of thing they haven't shown particularly large tightening, that would ordinarily mean a big negative macroeconomic hit. And that's because actually, some of the moves have been in opposite directions. So while measures of volatility have spiked higher, interest rates have on the whole moved lower, which is usually an easing in financial conditions. And although particular sub sectors of the equity market have moved dramatically, actually in broad equity indices, the moves have been somewhat smaller. And that means that you're not really seeing this macro spillover, transmitted through the financial conditions channel. But I think where we can expect to see it is through credit conditions or bank lending conditions and bank lending standards. Because these were already tightening pre the recent experience of the banking sector survey measures like the US Fed senior loan officer survey, the ECB’s bank lending survey, these were already pointing to some tightening in bank lending standards, which was I think, driven by higher interest rates. And now, with banks probably facing increased competition for deposits, raising deposit rates to keep hold of those deposits, possibly facing a squeeze on net interest margins, possibly seeing some increased risk aversion. I think we can expect to see further tightening in lending standards, in lending activity. And I think that's your main transmission channel of all this to the macro economy. And you also mentioned confidence Luke, confidence in the banking sector, well, actually, I wouldn't be surprised to see some of this playing out through consumer and business confidence, and seeing some of those kind of crucial high frequency survey measures of macro activity, weakening a bit as well.

Luke Bartholomew 08:28

And those spill overs that you mentioned there, Paul, I think they have quite important implications for this US recession forecast that we've had for some time, and the way we've approached that question is to divide it into two. So first, whether we think a recession is necessary to restore price stability in the US and the second as to whether the sufficient conditions are in place to cause such a recession. And I think what we've seen doesn't or shouldn't really change your assessment on the necessity of a recession. That's really a question that's to do with macroeconomic imbalances in the economy. So the degree to which the labour market is overheating how much inflation pressure there is. But I do think it has quite important implications, what we've seen, for the question of whether the sufficient conditions for recession are in place, and that's especially so in the context of the fact that the activity data in the US came in pretty strong at the start of this year, so many people forming the view that actually it didn't look like the conditions were in place for a near term recession, that it looked like the economy had managed to withstand much of the interest rate tightening that had occurred last year. And I think this is a reminder of, as you say, the large spillover effects which have recessionary consequences through tighter credit conditions through what they do to confidence. But also indirectly, they are a reminder of how much monetary tightening there is in the pipe still to come. Interest rates going up is the proverbial tide going out exposing all sorts of things that you may not wish to see. And I wouldn't be surprised if this is the end of that process.

Paul Diggle 10:22

Yeah, I think you have to be sort of updating your recession likelihood as a result of this experience. And, you know, I reminded Luke that we call our baseline global macro scenario, the one that involves a US led recession ‘Fed kills the cycle’. We started calling the baseline that back in the middle of 2022. And that sort of somewhat provocative or evocative name was chosen for a reason because, as you say, higher interest rates are the type of proverbial tide going out and the typical driver of the business cycle. Well the central bank has a very large role to play in it. Higher interest rates cause a weakening in macroeconomic conditions. The typical pattern has been to over tighten interest rates during an expansion phase because the central bank is operating with a lagged impact on the economy, reading the economy with data which is backward looking produced with a lag, subject to revision, so you know, they are driving in the rearview mirror, so to speak, and they typically over tighten, and on the other hand, during downturns can sometimes under tighten and cause subsequent inflationary periods as well. So I think we are seeing that play out and stresses in the banking sector are partly evidence of that ‘Fed kills the cycle’ dynamic occurring. While we didn't forecast exactly this particular experience, I think all this is consistent with an eventual US recession.

Luke Bartholomew 12:01

Well, on the topic of those business cycle killers, they're and this risk of potential over tightening. I mean, it is quite remarkable how much markets have repriced their expectations of Fed interest rate policy over the last couple of weeks and effectively taken out expectations for any more tightening. Now, I think our assessment is that that is probably somewhat overdone in the near term. Our sense is that central banks and the Fed in particular want to cling on to for now, this separation principle, the idea that the central bank has tools on the one hand that can be used for financial stability risk, whether they be liquidity tools, or whatever else it may be. And they have other tools, monetary policy tools, interest rate tools that they can use to deal with price stability issues. And whilst they're focused on price stability issues, at the moment, they can continue to push up interest rates and then use their other tools over here to deal with any financial stability concerns. And you know, that's the playbook that the Bank of England rolled out in October, November, last year, around the LDI issues, they injected liquidity and bought bonds to try and stabilise that market, whilst at the same time continuing to tighten monetary policy by pushing up interest rates. And that playbook is fine as far as it goes. But I suspect it only lasts so long. Because if we're right about a recession happening, then pretty quickly, both the imperatives of financial stability and the imperatives of monetary policy will end up pointing in the same direction. And that is the direction of easing policy. So at most we think the Fed will probably deliver another two 25 basis point rate increases. And I think risks are skewed to them doing less than that, to be honest.

Paul Diggle 14:08

Yeah, and that might hold for a variety of other central banks as well. You know, in the very near term, you could see a little bit more from the European Central Bank. Bank of England, I think is a little bit more of a toss up. But the bigger market driver, as I see it, Luke is that actually, we're going to see the start of a potentially quite substantial rate cutting cycle later this year that will accompany a broader macroeconomic downturn. And whether you get one or two more rate hikes from here is perhaps neither here nor there, when there's actually a large easing cycle to come. And we've got a view that actually even after recent market pricing changes with Fed Funds Futures markets incorporating a pretty substantial rate cutting cycle, perhaps around 100 basis points by the end of this year and more into 2024. Actually, a recession would see them doing much more than that. And it's not implausible, it's not wild to suggest that that cutting cycle could even be down as far as zero because the historically normal response of the Fed and other central banks to a recession is around 500 basis points of policy easing. That was different, every cycle, much depends on the starting point of interest rates where the neutral rate sits. But a broad rule of thumb could be that the medicine you administer, to fight a recession is around 500 basis points of rate cuts. And if you don't have that space, you also in recent cycles, do quantitative easing, as well. And then perhaps more quantitatively, you can actually well, we've done work, thinking through the appropriate monetary policy easing, given a particular growth and inflation outlook, so feeding in our GDP, and unemployment and, and interest rate forecasts, and sorry, inflation forecasts into the so-called Taylor Rules, these monetary rules, actually also, on average points to an easing cycle, that could be around 500 basis points of cuts, could potentially get the Fed Funds rate all the way back to around zero. And that seems an awful long way away from where we are now where the focus, you know, has been all about how high inflation has been, the speed of raising interest rates. But actually, I think the speed with which the market incorporated rate cuts around these financial sector worries, pricing out the end 2023 Fed Funds future, perhaps 150 basis points lower - that tells you something about how quickly thinking could shift in an actual macro downturn and in a genuine recession. And I think the other point I want to make is that even if the kind of recession / Fed kills the cycle’ scenario doesn't pertain, alternatives, like a softer landing for the US economy, or a long period of quite sticky inflation. Actually, these could involve interest rate cuts as well, they wouldn't be as deep. But given how far the Fed Funds rate sits above the neutral rate, I think you're also looking at rate cutting cycles in these kind of plausible alternatives, such that doing a sort of risk weighting across all plausible scenarios, I think, rates can actually decline more than then people currently are thinking.

Luke Bartholomew 17:54

So you mentioned their Paul that QE, quantitative easing might be something that you do when interest rates get back down to zero. But some people are actually saying that the Fed has, in fact, already started QE in the sense that its balance sheet has been expanding the last couple of weeks, had been in balance sheet rundown mode, due to Quantitative Tightening, allowing bonds to roll off its balance sheet and selling them back into the market. But yeah, the last couple weeks balance sheet expanded as a consequence of these liquidity operations that it's started to do since the SVB issues, and some people equating that run up in the size of the balance sheet as effectively just another form of QE. I'm not always convinced that litigating the definition of what exactly QE is or isn't is the most fruitful of things to do. We don't want to be in the business of policing terms. But at the same time, I think it is worth stressing that there are some quite important differences between what we would normally call QE and what we've been seeing over the last couple of weeks. Firstly, QE is purchases of government securities of one form or another. It's done when interest rates generally are at the effective lower bound. And the way it gets traction is about signalling the path of policy and, that’s at least typically, the way in which we think about how this policy works. It's a way of trying to show the market that the central bank really is committed to keeping interest rates low for a very long time. And that helps to lower the entire interest rate structure. It is very much monetary policy. It's designed to boost economic growth and inflation, whereas the liquidity measures that we've been seeing well they're lending, to start with, they're much more like the lender of last resort operations of a central bank rather than the monetary policy operations of a central bank. The quantity of reserves that are created is endogenous to the private sector’s demand. And indeed it is the reserve creation itself that has causal power. It is the provision of liquidity that's doing the work. Whereas in QE, we're already in a position of excess ample liquidity. So just adding reserves isn't really doing very much. The policy works, as I said, perhaps by signalling but in the case of liquidity provision, it really does matter that there are more reserves and the private sector has access to them. So they are quite different operations, QE and lender of last resort stuff that we've been seeing recently. So I think it would be wrong regardless of what you want to define them as to think that the impacts of what we've seen recently will have the same impacts that QE has had over the last 15 years or so.

Paul Diggle 20:54

Luke, brilliant. That's all we have time for today. Let's see if we're going to be returning to this issue in future episodes or not. For now, the next episode is going to be diving into the UK economy in particular. In the meantime, thank you as ever for listening to Macro Bytes. Please like and subscribe on your podcast platform of choice. Until next time, Goodbye and good luck out there.

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