Borrowing could become tougher, a particular blow to small businesses — and a threat to the recovery’s staying power.
March 17, 2023Updated 2:02 p.m. ET
The U.S. economic recovery has repeatedly defied predictions of an impending recession, withstanding supply-chain backlogs, labor shortages, global conflicts and the fastest increase in interest rates in decades.
That resilience now faces a new test: a banking crisis that, at times over the past week, seemed poised to turn into a full-blown financial meltdown as oil prices plunged and investors poured money into U.S. government debt and other assets perceived as safe.
Markets calmed somewhat by the end of the week amid hopes that swift action by leaders in Washington and on Wall Street would keep the crisis contained to the small and midsize banks where it began.
But even if that happened — and veterans of previous crises cautioned that was a big “if” — economists said the episode would inevitably take a toll on hiring and investments as banks pulled back on lending, and businesses struggled to borrow money as a result. Some forecasters said the turmoil had already made a recession more likely.
“There will be real and lasting economic repercussions from this, even if all the dust settles well,” said Jay Bryson, chief economist at Wells Fargo. “I would raise the probability of a recession given what’s happened in the last week.”
At a minimum, the crisis has complicated the already delicate task facing officials at the Federal Reserve, who have been trying to slow the economy gradually in order to bring inflation to heel. That task is as urgent as ever: Government data on Tuesday showed that prices continued to rise at a rapid clip in February. But now policymakers must grapple with the risk that the Fed’s efforts to fight inflation could be destabilizing the financial system.
They don’t have long to weigh their options: Fed officials will hold their next regularly scheduled meeting on Tuesday and Wednesday amid unusual uncertainty about what they will do. As recently as 10 days ago, investors expected the central bank to reaccelerate its campaign of interest rate increases in response to stronger-than-expected economic data. Now, Fed watchers are debating whether the meeting will end with rates unchanged.
The notion that the rapid increase in interest rates could threaten financial stability is hardly new. In recent months, economists have remarked often that it is surprising that the Fed has been able to raise rates so much, so fast without severe disruptions to a marketplace that has grown used to rock-bottom borrowing costs.
What was less expected is where the first crack showed: small and midsize U.S. banks, in theory among the most closely monitored and tightly regulated pieces of the global financial system.
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What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
“I was surprised where the problem came, but I wasn’t surprised there was a problem,” Kenneth Rogoff, a Harvard professor and leading scholar of financial crises, said in an interview. In an essay in early January, he warned of the risk of a “looming financial contagion” as governments and businesses struggle to adjust to an era of higher interest rates.
He said he did not expect a repeat of 2008, when the collapse of the U.S. mortgage market quickly engulfed virtually the entire global financial system. Banks around the world are better capitalized and better regulated than they were back then, and the economy itself is stronger.
“Usually to have a more systemic financial crisis, you need more than one shoe to drop,” Professor Rogoff said. “Think of higher real interest rates as one shoe, but you need another.”
Still, he and other experts said it was alarming that such severe problems could go undetected so long at Silicon Valley Bank, the midsize California institution whose failure set in motion the latest turmoil. That raises questions about what other threats could be lurking, perhaps in less regulated corners of finance such as real estate or private equity.
“If we’re not on top of that then what about some of these other, more shadowy parts of the financial system?” said Anil Kashyap, a University of Chicago economist who studies financial crises.
Already, there are hints that the crisis may not be limited to the United States. Credit Suisse on Thursday said it would borrow up to $54 billion from the Swiss National Bank after investors dumped its stock as fears arose about its financial health. The 166-year-old lender has faced a long series of scandals and missteps, and its problems aren’t directly related to those of Silicon Valley Bank and other U.S. institutions. But economists said the violent market reaction was a sign that investors were growing concerned about the stability of the broader system.
The turmoil in the financial world comes just as the economic recovery, at least in the United States, seemed to be gaining momentum. Consumer spending, which fell in late 2022, rebounded early this year. The housing market, which slumped in 2022 as mortgage rates rose, had shown signs of stabilizing. And despite high-profile layoffs at large tech companies, job growth has stayed strong or even accelerated in recent months. By early March, forecasters were raising their estimates of economic growth and marking down the risks of a recession, at least this year.
Now, many of them are reversing course. Mr. Bryson, of Wells Fargo, said he now put the probability of a recession this year at about 65 percent, up from about 55 percent before the recent bank failures. Even Goldman Sachs, among the most optimistic forecasters on Wall Street in recent months, said Thursday that the chances of a recession had risen 10 percentage points, to 35 percent, as a result of the crisis and the resulting uncertainty.
The most immediate impact is likely to be on lending. Small and midsize banks could tighten their lending standards and issue fewer loans, either in a voluntary effort to shore up their finances or in response to heightened scrutiny from regulators. That could be a blow to residential and commercial developers, manufacturers and other businesses that rely on debt to finance their day-to-day operations.
Janet L. Yellen, the Treasury secretary, said Thursday that the federal government was “monitoring very carefully” the health of the banking system and of credit conditions more broadly.
“A more general problem that concerns us is the possibility that if banks are under stress, they might be reluctant to lend,” she told members of the Senate Finance Committee. That, she added, “could turn this into a source of significant downside economic risk.”
Tighter credit is likely to be a particular challenge for small businesses, which typically don’t have ready access to other sources of financing, such as the corporate debt market, and which often rely on relationships with bankers who know their specific industry or local community. Some may be able to get loans from big banks, which have so far seemed largely immune from the problems facing smaller institutions. But they will almost certainly pay more to do so, and many businesses may not be able to obtain credit at all, forcing them to cut back on hiring, investing and spending.
“It may be hard to replace those small and medium-size banks with other sources of capital,” said Michael Feroli, chief U.S. economist at J.P. Morgan. “That, in turn, could hinder growth.”
Slower growth, of course, is exactly what the Fed has been trying to achieve by raising interest rates — and tighter credit is one of the main channels through which monetary policy is believed to work. If businesses and consumers pull back activity, either because borrowing becomes more expensive or because they are nervous about the economy, that could, in theory, help the Fed bring inflation under control.
But Philipp Schnabl, a New York University economist who has studied the recent banking problems, said policymakers had been trying to rein in the economy by crimping demand for goods and services. A financial upheaval, by contrast, could result in a sudden loss of access to credit. That tighter bank lending could also affect overall supply in the economy, which is hard to address through Fed policy.
“We have been raising rates to affect aggregate demand,” he said. “Now, you get this credit crunch, but that’s coming from financial stability concerns.”
Still, the U.S. economy retains sources of strength that could help cushion the latest blows. Households, in the aggregate, have ample savings and rising incomes. Businesses, after years of strong profits, have relatively little debt. And despite the struggles of their smaller peers, the biggest U.S. banks are on much firmer financial footing than they were in 2008.
“I still believe — not just hope — that the damage to the real economy from this is going to be pretty limited,” said Adam Posen, president of the Peterson Institute for International Economics. “I can tell a very compelling story of why this is scary, but it should be ok.”
Alan Rappeport and Jeanna Smialek contributed reporting.