In a previous article “Aviation, Pay Attention To The ‘Canary In The Coal Mine’’ we advise readers to pay attention to the canary in the coal mine. By canary we mean the banks themselves. Banks are solid indicators of severe economic challenges ahead. When Banks begins to fail then you know that things are not going well. We believe this is because of two main reasons. First, the banks are intricately connected with the federal reserve and can receive liquidity injections to keep them afloat when needed. Second, the banks are the backbone of the financial system which in itself has become the backbone of the wider economy.
Over the weekend First Republic Bank failed and a deal was struck for it to be taken over by JP Morgan Chase Bank. Yet, that’s not the end of it. So far this week we have two more canaries that are looking quite ill. Currently it would seem that the regional banks PacWest and Western Alliance are teetering on the brink of collapse.
As we stated in our On Aviation™ Podcast, what’s happening currently is being called a banking crisis, but this is a misnomer. Whether deliberately or not the mainstream is not admitting that we are currently well into the beginning phase of an economic crisis. Just like with the 2008 great recession – though the catalyst was different as that was in subprime mortgages – it started with the collapsing of banks.
The Federal Reserve yesterday (May 3, 2023) raised the key interest rate by another 0.25%. Many economists as well as us believe that Interest rates need to be well above inflation to have any real impact on inflation. However, interest rates do not have to be very high to have a severe impact on equity markets, the economy, and in particular the banks, as we are seeing currently. It is our belief that the Federal Reserve is hoping that an economic contraction will solve the inflation problem. We think otherwise. We believe that this will only lead to an economic contraction coupled with higher inflation. This has been dubbed stagflation.
It is at this point that we would like to remind our readers that inflation will not be coming down anytime soon. This is because the underlying factors which include fiscal and monetary policies – primarily fiscal policies – are not changing in a positive way and in fact they are increasing. Surely by now we don’t have to explain to our readers again the importance of understanding what’s happening here.
In this week’s full article, we will share some insights into what has been going on with the banks, and shed some light as to what we can expect in the future.
For related readings, please see also: ‘3 Ways Aviation Businesses Are Coping With Inflation’, ‘The Aviation Industry and Economic Uncertainties’, ‘Inflation: Higher costs and their effects on Flight Schools’, ‘High Interest Rates/Cost of Borrowing and Their Effects on Aviation Businesses’,’Debt: Its effects on the Aviation Industry’, ‘Economic Crisis and the Aviation Industry’, ‘Inflation and Aviation’, ‘How The Aviation Industry Needs To Look At Inflation’, ‘The Aviation Industry Must Not Mistake A Recession’, ‘Understanding Recessions’, ‘Understanding Inflation’, ‘Money and Recessions.’, ‘Breaking Down Inflation.’ , ‘Inflation: Here we go again…’’, ‘Recession: Should we still be concerned?’, ‘Stagflation: Should the Aviation Industry be Concerned?’ ‘Aviation: Producer and Consumer Prices’, ‘Aviation: Are We In BIG Trouble?’, ‘Aviation: Recession Red Flags?’, and ‘Aviation, Pay Attention To The ‘Canary In The Coal Mine’’
The Federal Reserve’s Federal Open Market Committee (FOMC) on Wednesday raised the target policy interest rate (the federal funds rate) to 5.25 percent, an increase of 25 basis points. With this latest increase, the target has increased 5 percent since February 2022. This is the highest rate reached since August 2007, shortly before a recession began in December of that year.
With an increase of only 25 basis points, the May meeting is the third month in a row during which the Fed has pulled back from its more substantial rate hikes of 2022. After four 75-basis-point increases in 2022, the committee approved a 50-point increase in December, followed by 25-point increases in February and March, and another on Wednesday.
Although CPI inflation has remained at or above five percent in recent months the FOMC has slowed down in its monetary tightening over the past four months. This is spite of the fact Powell today characterized price inflation as “well above” the two-percent target while concluding the Fed “has a long way to go” in terms of getting price inflation under control. Nonetheless, indications continue to mount that the Fed is maintaining its drift toward more dovish policy.
This was apparent in Powell’s comments on the state of the economy on Wednesday. The Fed uses most indications of economic weakness as excuses to embrace monetary easing, and the Fed now increasingly points to weakening growth. In his remarks, Powell said “the US economy slowed significantly last year” while noting the pace of growth “continued to be modest” into the spring. Although Powell, as usual, pointed to “strong” job growth numbers, he did not present this as a clear indicator of the overall economy. Instead, the discussion turned toward the Fed’s economic forecasts which, according to Powell, point to a “mild recession.” Sticking to the usual script however, Powell emphasized the word “mild” and predicted employment losses as a result of a coming recession would be “smaller than is typical in recessions.” Given that the Fed has demonstrated no prescience whatsoever in terms of forecasting inflation rates or economic growth in recent years, it’s unclear as to what gives Powell the confidence to make such a precise prediction.
The FOMC’s press release text also points toward a policy turn away from monetary tightening. For example, in March’s press release, the FOMC noted:
The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.
In contrast, this is what Wednesday’s statement reads:
In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
Powell emphasized this change in this remarks during the press conference nothing that the committee no longer assumes additional “policy firming” is necessary. Rather, the committee will look into if additional firming is necessary in the future. In other words, FOMC policy and outlook could change at any time. The Fed has long since abandoned forward guidance, and now explicitly makes policy on a month-to-month basis. This, of course, makes sense given that the Fed has repeatedly been shown to lack any insight into economic trends, following 2022 debacle over “transitory” inflation and numerous Fed officials’ proclamation that no rate hikes would necessary before late in 2023.
A Looming Threat of Bank Failures
Perhaps the most recent—and alarming—demonstration of the Fed’s disconnect from reality comes from the Fed’s repeated failures to foresee or address mounting bank failures.
2023 has already seen three major banks failures. As The New York Post reported on Monday:
The three US banks that collapsed this year — First Republic, Silicon Valley Bank and Signature Bank of New York — had more combined assets under management than all 25 federally insured lenders that failed in 2008 at the onset of the Great Recession.
This is apparent in this helpful graph created by Mike Bostock, large bank failures in the early days of the 2007-2008 crises were followed by hundreds of failures at smaller banks. If 2023-2024 follows a pattern similar to that of 2007-2008, the banking system is in a lot of trouble.
Perhaps in an attempt to calm the banking sector, Powell was sure to declare at the FOMC press conference that the banking system is “sound and resilient.” Yet, within hours of the press conference, two more banks were showing signs of extreme stress. Regional banks PacWest and Western Alliance saw their stock prices crash in after-hours trading. As of 7 PM Eastern on Wednesday, PacWest’s stock is down 55 percent, and Western Alliance is down by 20 percent. In other words, Powell professed confidence in the banking system required only a few hours to look very misplaced, indeed. Both banks have recently reported increasing threats to profitability.
Complacency about the Banking sector appears to be fashionable at the Fed, however. In today’s press conference, CNBC’s Steve Liesman—the only reporter who asks tough questions at these press conferences—asked Powell why the Fed has done so little to address the increasingly obvious structural weaknesses in the banking sector. (Liesman asked a similar question at the March meeting, to which Powell responded with a deer-in-the-headlights look.) Powell responded to Liesman’s question with no details except to insist the Fed has the situation under control and to say that things are fine because banks are actively seeking more liquidity.
What Powell failed to mention is that this search for liquidity is becoming more and more difficult the higher interest rates rise. As the Fed allows rates to return to more normal levels after a decade of financial repression, depositors are moving their money elsewhere in a search for yield above the paltry interest that banks pay in deposits.
The Fed’s Low-Interest Bubble
There is no clear way out of this for banks, however. The banking sector has become extremely reliant on business models that assume extremely low interest rates. If interest rates continue to head upward, banks will increasingly find themselves in a position of having to pay out interest at higher rates than they can collect on the older low-interest assets on the banks’ balance sheets. In other words, banks will find themselves with negative cash flow and will become insolvent. Given Powell’s response to Liesman’s question, it is also apparent the Fed has no strategy here except to pump more liquidity—i.e., easy money—into the banking system. Given that price inflation is already well above targets, and at a 35-year high, it’s unclear how the Fed thinks it can do this without making price inflation further entrenched.
After all, the Fed’s target policy rate remains quite low compared to price inflation. Historically—prior to 2008—the policy rate tended to exceed the CPI inflation rate except in recessionary periods when the Fed was explicitly attempting to “stimulate” the economy out of a recession. Since 2008, however, the relationship has reversed and the Fed has continually pushed the target rate below CPI price inflation. With this latest rate hike, the FOMC brings the target rate slightly above the CPI inflation rate (for April) of 5 percent. Powell is likely right that the Fed still has a long way to go before bringing inflation down near the two-percent target.
If the Fed is serious about bringing down price inflation, however, it’s difficult to see how the Fed can do that while also guaranteeing more liquidity to an obviously fragile banking system. We may be on the leading edge of a new wave of bank failures, the total size of which could dwarf the bank failures of 2008.
Ryan McMaken (@ryanmcmaken) is executive editor at the Mises Institute. Send him your article submissions for the Mises Wire and Power and Market, but read article guidelines first. Ryan has a bachelor’s degree in economics and a master’s degree in public policy and international relations from the University of Colorado. He was a housing economist for the State of Colorado. He is the author of Breaking Away: The Case of Secession, Radical Decentralization, and Smaller Polities and Commie Cowboys: The Bourgeoisie and the Nation-State in the Western Genre.
This article was originally published on the Mises Wire on May 03, 2023, with the title “Jay Powell Said the Banking System Is “Sound and Resilient.” Now More Banks Are in Trouble.”. The views expressed are the author’s, and do not constitute an endorsement by or necessarily represent the views of On Aviation™ or its affiliates.
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