Financial shock sending Fed proxy rate into restrictive terrain

  The financial shock affecting the U.S. economy will most likely result in tightened lending standards, tip the economy into recession this year and cause mild disinflation. The quandary faced by the Federal Reserve—balancing price stability, full employment and financial stability—requires an estimate of just how large that shock will be. The counterfactual analysis we present here implies that our estimate of the shock is equivalent to 50 basis points of policy tightening as long as the current crisis does not deteriorate further and financial conditions remain tightened. This creates a proxy rate one half of one percent higher than wherever the policy rate rests following the Federal Reserve’s decision on Wednesday. That proxy rate will move well into restrictive terrain and most likely create the conditions for a near-term peak in the policy rate. Should the crisis deteriorate further, with more bank seizures and further problems inside systemically important financial institutions, then the degree of financial shock is equivalent to 150 basis points of tightening. If the Fed increases its policy rate by 25 basis points on Wednesday, to a range of 4.75% to 5% from 4.5% to 4.75%, the proxy rate would be the equivalent of 5.25% to 5.5%, and that would most likely be the final rate hike in this cycle, all else being equal. That is a big “if,” given the uncertainties around inflation in recent months. It is important for the market, especially financial institutions, to treat these uncertainties with the utmost priority. Our estimates work only if our key assumption—that banks have learned not to underestimate the Fed’s determination to restore price stability—holds. Failing to account for upside inflation risks and, ultimately, upside credit risks by prematurely pricing for rate cuts would lead to the same vicious cycle. By contrast, the loosening of financial conditions in anticipation of rate cuts would mean stickier inflation, more rate hikes, and more bank failures. More ominously, should the Fed hike by 25 basis points and financial conditions deteriorate, it would be the equivalent of a proxy rate closer to 6.5%. At that point, the Fed would have created the conditions for a deeper recession than necessary to obtain price stability, at the cost of much higher unemployment.

Scenarios

We subject the economy to a shock to estimate two counterfactual scenarios where the peak policy rate would otherwise be roughly 5%.

• Liquidity crisis: The first is a shock along the lines of the one affecting the economy and does not materially deteriorate or abate until the end of the second quarter. While credit risk and pervasive uncertainty remain, recent policy steps are sufficient to prevent the liquidity crisis from transforming into an economy-wide credit crunch. This implies that the Fed is well positioned to hike the policy rate by 25 basis points or could choose to pause with the knowledge that the proxy rate would climb to somewhere between 5% and 5.25%. The consumer price index under this scenario would return to near the Fed’s 2% inflation target by the end of next year.
• Credit crunch: In our alternative to the baseline, the crisis intensifies with more bank failures and bank seizures, causing extreme volatility across asset classes, hurting systemically important financial institutions and resulting in a credit crunch that would lead to an increase of 150 basis points in the policy rate. Under this scenario, inflation would return to a rate below the 2% target to roughly 1.8% by the end of next year.

The takeaway

Judgment calls on policy are always difficult. During a banking crisis, it is impossible to balance the need to restore price stability against rising unemployment and financial stability. Our estimate of where this balance lands is not encouraging. At the very least, the current shock, if it is contained and does not abate until midyear, is equal to roughly 50 basis points of policy tightening. Alternatively, should conditions deteriorate, then the tightening of financial conditions would be equal to roughly 150 basis points of policy restriction. This is the difference between a liquidity crisis, which we are in, and a broader credit crunch, which has yet to happen. Whatever the case, the financial shock hitting the economy will result in the Fed pushing its policy rate well into restrictive terrain and create the conditions for a near-term peak as lending becomes tight. Such is the price of a banking crisis when inflation remains elevated.