Smith Brain Trust / April 20, 2023

Smith Experts React to Fed Recession Prediction

Smith Experts React to Fed Recession Prediction

Federal Reserve economists predicting a mild recession as a result of the recent banking crisis has drawn varied and incisive responses from finance experts at the University of Maryland’s Robert H. Smith School of Business.

Professor of the Practice Clifford Rossi recently told that a small recession is likely but not approaching the caliber of 2008 (But keep an eye on market liquidity and any further banking turmoil as wildcards that lead to a downturn, he added). Meanwhile, here’s what his colleagues Michael Faulkender, David Kass, Albert “Pete” Kyle and Bill Longbrake want readers to know:

Michael Faulkender, Dean’s Professor of Finance and former Assistant Secretary for Economic Policy at the US Department of Treasury (He references his discussion from April 1 and 8 WABC Radio appearances)

I said (on April 1) the economic outlook ‘is not that great. If you look at the PCE (personal consumption expenditures, which make up about 65% of GDP) number for February, the real number was negative. There was a blockbuster January, but November, December and February were all down in real (inflation adjusted) terms. The economy is not in a strong position. These results were the case before the SVB and Signature Bank collapses. Following those, households will naturally pull back further, and banks have significantly tightened their credit standards. Manufacturing and housing are both in slumps but again that started well before SVB.’

On April 8, I expanded on these comments, including, ‘It keeps coming back to when are households going to finish burning through the money that they accumulated during the pandemic? More and more of them are hitting credit card debt limits. We’ve been watching checking and savings account deposits at banks slowly declining. It’s when that spending stops that we will hit a recession and we will. When you’ve got negative real wages and savings rates where they are at, a lot of households are burning through the cash they accumulated. The question is: When will they burn through enough of it that they will be forced to pull back and we’ll get the inevitable recession? It will be shallow. But we will get it because people will pull back because the current spending levels are unsustainable in a negative real wage environment.’

The bottom line is that I do not agree with characterizations of a recession coming because of the closures of SVB and Signature. The pandemic spending policies of the Biden Administration were totally unnecessary. It is not the banks that will lead us into recession. There were excessive government transfers to households. Those have stopped but the households are still spending through that money. Once that money dries up, they will have to pull back and we will have a recession. Very little to do with the $20 billion bailout of SVB.

David Kass, Clinical Professor of Finance, who formerly held senior positions with the Federal Government (Federal Trade Commission, General Accounting Office, Department of Defense, and Bureau of Economic Analysis)

I agree with the recent Fed forecast for a mild recession occurring in late 2023. The failures of Silicon Valley Bank and Signature Bank, and the likely increase of the Federal Funds rate by another 25 basis points to 5.00-5.25% at the next FOMC meeting on May 2-3 will result in sufficiently tight credit conditions so that a ‘soft landing’ is unlikely to occur. The Federal Reserve’s goal of 2% core PCE (personal consumption expenditure) inflation is not expected to be achieved until 2025 according to the March 22, 2023, economic projections of the Federal Reserve Board members and Federal Reserve Bank presidents. Core PCE inflation is projected to decline to only 3.6% by year-end 2023. In addition, every recession since World War II, prior to the recession resulting from the 2020 pandemic, was preceded by the Federal Reserve raising interest rates. The likely mild recession in late 2023 would be consistent with this track record. The current historically low unemployment rate of 3.5% is projected to increase to only 4.5% in late 2023 and then 4.6% in 2024 and 2025, before declining to 4.0% in the longer run, according to the Federal Reserve Board. This would be indicative of a mild recession.

Albert “Pete” Kyle, Charles E Smith Chair in Finance and Distinguished University Professor

The fast collapse of SVB indicates a failure of bank supervision. This failure is likely to be costly, and the costs are likely to show up as a recession which is severe, not mild. The Dodd-Frank Act focused more on heavy-handed regulation than on higher capital requirements to make banks financially healthy. Bank regulators must have known about the unrealized losses on mortgage and Treasury securities which crippled SVB's balance sheet. These are transparently obvious from cursory oversight. They apparently did not do enough to force SVB to recapitalize until it was too late. As a result of this regulatory forbearance, the FDIC, which ultimately uses the money of taxpayers to take over failed banks, faces billions of dollars in losses.

The regulatory failure was not the result of exempting banks like SVB from stress tests. Ordinary bank regulatory oversight, operating independently from stress tests, certainly picked up the problems at SVB well before it collapsed.

The idea that uninsured depositors will monitor banks adequately is known not to work well. Its mechanism of enforcement is bank runs, which---once started---spread to the entire banking system and rapidly send an economy into a recession. The government knows that steep recessions are an absurdly high price to pay for bank monitoring. The entire purpose of the Dodd-Frank Act was to provide a regulatory system which would prevent bank failures without causing recessions. Therefore, it is surprising that the government even thought about wiping out uninsured depositors of SVB as a mechanism of maintaining financial discipline in the banking sector.

The commercial real estate sector of the U.S. economy is facing a disaster. Commercial office space lease rates are falling, commercial real estate debt is coming due, and many commercial real estate ventures will likely be insolvent when loans fall due. This disaster is unfolding slowly because leases and loans typically last five to ten years. It becomes apparent when leases do not roll over and loans cannot be repaid. Much of the risk has probably found its way into the banking system, especially into the portfolios of medium-sized banks. Since regulators failed to force SVB to fix obvious problems with SVB's balance sheet, investors and bankers alike are likely to infer that regulators will also fail to force banks burdened with less obvious bad commercial real estate debt to recapitalize promptly.

The 2008 financial crisis was largely triggered by bad residential mortgage loans. We are potentially facing another crisis, this time driven by those bad loans. I expect a recession to unfold if and when it becomes apparent that banks are too undercapitalized to function properly. This recession might resemble the recession in the early 90s, which was a delayed response to banking problems within the savings and loan industry. Whether this recession unfolds sooner or later depends on the speed with which the government acts to force banks to recapitalize. The Fed's prediction of a mild recession this year suggests they will do too little, too late. Immediate action might trigger a more severe recession now, which would be a small price to pay for a healthy economy a few years later.

Nevertheless, there are reasons to expect the recession to unfold sooner rather than later. In addition to weakly capitalized banks, the economy has also been dealing with an inflation problem. The Fed has made a commitment to bring the inflation rate down to two percent annually. Unlike government regulators' commitments to require banks to be well-capitalized, this commitment has some credibility because, if the Fed is unable to rid the economy of inflation, the Fed itself will become obviously insolvent and lose so much credibility that the independence of the Fed will be threatened. Reducing inflation will exacerbate the debt burden of commercial real estate borrowers because the value of their collateral will fall faster with a lower rate of inflation and high interest rates needed to bring inflation down will make rolling over debt more costly.

The underlying problem is that heavy-handed government regulation leads to regulatory capture. The more that is at stake, the more resources regulated entities devote to influencing government policy. The Dodd-Frank Act, rather than creating a healthy banking industry, has created a noncompetitive, undercapitalized banking system, which has captured its regulators and is prone to collapse.

If governments subsidize risk taking by allowing banks or other companies to function as if things are normal when they are inadequately capitalized, the banks or other companies will embrace poor capitalization because they believe they can keep their gains but dump their losses on taxpayers. Ultimately, many banks and other companies will fail because their bets did not work out. These failed companies will be nationalized by the FDIC or other government agencies. During the past financial crisis, the government quickly sold off nationalized companies like General Motors and AIG. It gave banks generous bailouts to avoid formally nationalizing them. When banks and other firms start failing again, we do not know whether the government will hold the failed firms as nationalized companies or let them go public again. In my opinion, the government allowed banks to remain in the private sector last time because bailing out banks (with cheap equity from the TARP program) did not cost taxpayers too much out of pocket: Bank stocks rebounded quickly from their depressed prices. By contrast, in the savings and loan debacle, getting out from under government ownership took more than a decade because the industry did not rebound as a whole. If regulators allow the banking system to become too undercapitalized, the hole to dig out of will become so big that nationalization may not be followed by quick privatization. The road to socialism is paved with debt.

The collapse of the commercial real estate sector may be accompanied by the collapse of the finances of some big cities. As the politics of many cities–such as Chicago, San Francisco, and New York–moves to the left, many high-income taxpayers are migrating from these cities to other cities with lower taxes and more business-friendly environments. Some of these cities may face major financial stress in coming years, and this will exacerbate their commercial real estate problems.

William Longbrake, Executive-in-Residence and Senior Policy Advisor for the Center for Financial Policy

In the wake of the failures of Silicon Valley Bank and Signature Bank in mid-March, the Fed staff downgraded its economic outlook for the U.S. economy at the March 22nd meeting of the Federal Open Market Committee (FOMC) to “a mild recession starting later this year, with a recovery over the subsequent two years.” Economic activity and employment were forecast to be weaker than the staff’s previous forecast in January. Inflation was forecast to drop sharply to near the FOMC’s 2% objective in 2024.

Staff’s pessimistic outlook resulted from expectations that banking stress spawned by the recent bank failures would cause a significant tightening in credit standards that would accelerate the slowdown in economic activity and cause higher unemployment.

However, Fed staff emphasized that “the uncertainty around the baseline projection was much greater than at the time of the previous forecast.” Importantly, upside or downside risks to its projections will depend on the development of banking conditions and, more broadly, financial conditions.

Analysts busied themselves estimating the potential economic impacts of tighter credit and financial conditions. Goldman Sachs estimated that real GDP growth in 2023 might be reduced by 0.25% to 0.50% but would still be positive for the year – slower growth but no recession. Evercore ISI estimated that real GDP growth would fall nearly 1.0% and agreed with the Fed staff’s mild recession outlook.

The combined impacts of the FDIC’s exercise of its systemic risk power to protect all depositors, both insured and uninsured, and the Fed’s creation of a lending facility backed by the face value of collateral, rather than the market value, for one year at a competitive interest rate have helped stabilize financial markets over the past month.

Thus, it might seem that the risks of tighter credit conditions might have abated and that the Fed staff’s economic projections are too pessimistic. But it is premature to be confident about that. Evercore ISI concluded a survey of 56 companies in mid-April and found that 30% reported credit conditions were a little tighter (13%), tighter (13%), or a lot tighter (4%). The Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS), expected to be released in early May, will cover April and May, and is expected to provide more definitive information about credit tightening following the recent bank failures.

While we wait for more concrete information, some depositors have shifted funds from large regional banks to mega banks, such as JPMorgan, which reported its deposits increased $50 billion in Q1. Large regional banks have had to raise deposit interest rates more than they anticipated to retain those funds. This will weigh on future profitability and lower profitability historically is correlated with reduced lending. A market indicator of this development is that stock prices of large regional banks, which fell sharply at the time of the bank failures, have recovered only a little.

At its March 22nd meeting, the FOMC decided to raise the federal funds rate 25 basis points, choosing to continue its fight to bring inflation down. It projected at least one more increase of 25 basis points in 2023 and no rate cuts until 2024. While FOMC participants, unlike the Fed staff, do not expect a recession to develop, they acknowledged that going forward the risks to economic activity and employment are skewed to the downside.

As Governor Waller, a member of the Federal Reserve Board of Governors, recently pointed out, there hasn’t been much progress to date in bringing down the core inflation rate. The good news, however, is that increases in wage rates are decelerating and long-term inflation expectations remain anchored and consistent with the Fed’s 2% inflation objective. But there is risk that core inflation gets stuck at too high a level. If that becomes evident, the FOMC may feel compelled to maintain a tight monetary policy for longer.

Historically, monetary policy tightening cycles expose weaknesses as the cycle progresses. The recent bank failures reflect that historical evolution. But history indicates that it is never one and done – additional destabilizing events occur until the tightening cycle reverses.

Weaknesses that built up in the recent years of ultra easy monetary policy and extraordinarily generous fiscal policy have yet to be rooted out. The next shoe to drop likely will involve loan defaults and losses. Real estate loans secured by office buildings are a prime candidate for coming trouble. Some of the large regional banks figure prominently in this type of lending.

Acknowledging that there is a high degree of uncertainty, it is my view that the preponderance of the evidence, including the current stance of monetary policy, and historical precedent point in the direction of recession. While those who expect recession almost universally agree that it will be a mild one, it would be foolhardy to dismiss the possibility of a much more severe recession.

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