REAL ECONOMY BLOG | March 21, 2023 | Authored by RSM US LLP
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.
We subject the economy to a shock to estimate two counterfactual scenarios where the peak policy rate would otherwise be roughly 5%.
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.
Call us at (541) 773-6633 (Oregon), (208) 373-7890 (Idaho) or fill out the form below and we’ll contact you to discuss your specific situation.
This article was written by Joseph Brusuelas, Tuan Nguyen and originally appeared on 2023-03-21.
2022 RSM US LLP. All rights reserved.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.