Powell says credit crunch is doing the work of Fed’s rate hikes

Banks that got spooked by huge failures in their sector earlier this year and tightened lending to protect their margins are picking up where the Federal Reserve may be leaving off when it comes to further interest rate increases.

The private credit crunch resulting from three of the largest bank failures in U.S. history — all of which catered to extremely wealthy customers who were promptly bailed out well above the standard $250,000 insurance limit by the Federal Deposit Insurance Corporation (FDIC) — may be taking the Fed off the hook for more rate hikes, Fed Chair Jerome Powell suggested Friday.

“While financial stability tools helped to calm conditions in the banking sector, developments there … are contributing to tighter credit conditions,” Powell said. “So as a result, our policy rate may not need to rise as much as it would have otherwise to achieve our goals.”

The Fed’s latest rate hike earlier this month put interest rates in the range of 5 percent to 5.25 percent, meeting the bank’s latest terminal projection for where rates should end up this year. That means the Fed doesn’t have to worry about credibility concerns and delivering on earlier promises but can simply react to what’s happening in the economy in deciding where to move interest rates next.

Central bankers expect to lower rates to 4.3 percent next year and to 3.1 percent in 2025, as consumer inflation continues to fall from its peak of 9.1 percent in 2022.

The bank failures and response from the financial sector may be hastening the U.S. economy toward a recession, which the Fed has been predicting since March.

Conditions in the financial sector “are likely to weigh on economic growth and hiring and inflation,” Powell said Friday.

Former Federal Reserve Chair Ben Bernanke described the failures and response from the FDIC and the Fed, which extended a special line of credit backstopped by taxpayer money, as following “the standard sequence” from faulty management, a subsequent bank run and a fear of “contagion.”

Bernanke differentiated the latest bank failures from the ones during the global financial meltdown of 2007 and 2008, which resulted from predatory loans made to people who couldn’t afford them. Investment banks were bailed out by Congress for the money they lost while mortgage holders lost their homes.

Market commentators and even federal regulators have noted that the “bailout culture” of recent decades marks a departure from some of the assumed norms of free enterprise capitalism in which businesses that fail due to poor management or external forces do not get artificially resuscitated by the state sector.

“We should plan for those bank failures by focusing on strong capital requirements and an effective resolution framework as our best hope for eventually ending our country’s bailout culture that privatizes gains while socializing losses,” FDIC board member Jonathan McKernan wrote in a statement following the FDIC takeover of First Republic Bank.

“The March 12 rescue of SVB and Signature’s uninsured depositors was an admission that 15 years of reform efforts have not been a success,” he added.

Further stress on financial markets is coming from the refusal so far of Congress to raise the debt ceiling, which could force a default on U.S. public debt. At issue in the debt negotiations among Congressional leaders and the White House are paperwork requirements for programs that help low-income Americans, including food stamps and welfare.

International economic conditions that facilitated low inflation over the past several decades may be changing, Powell noted Friday.

“Positive supply shocks related to globalization … probably contributed significantly to the period of low inflation that either ended or was interrupted by the onset of the pandemic,” he said.

“I’m thinking there of the vast increase in the global labor supply, the development of efficient global supply chains facilitated by technological advances and things like that. And I would say those positive supply shocks do not seem likely to be repeated,” Powell said.

While companies passed on to consumers the higher costs incurred by backups in the supply chain at the beginning of the pandemic, they were able to keep prices higher and increase profit margins as the pandemic wore on simply because consumers had been conditioned to pay more.

This is known as a profit-price cycle and is the opposite of what happened in the 1970s, when wages and labor costs were associated with higher prices, and monetary tightening was carried out in concert with labor contract renegotiation. Wages have not kept pace with inflation during the current cycle.

Some commentators have noted the way to combat profit-led inflation is to encourage consumers to revolt in the form of making fewer purchases, which could prompt companies to lower their margins in order to clear inventories and compete for sales.