- No major risk of short-term financial instability
- ECB continues unperturbed
- US inflation picture more favorable than ours…
- …but the Fed will continue to raise interest rates next week
- Chinese economic activity is recovering, but slowly
Google Translated from Dutch to English. Here is the link to the original article in Dutch. The article was originally published on 17 March 2023.
This is not 2008!
Turmoil in the financial markets and mistrust of banks evoke memories of the Great Financial Crisis of 2008/09. Unjustified in my opinion. The differences between them are much greater than the similarities and those differences are of a decisive nature. Here are four crucial ones:
• First, the core of the problem at the time was the slump in the US housing market and the associated fall in the value of US residential mortgages, which are widely distributed in the global financial system and which are rather dubious. That market dried up completely and no one knew what the paper was worth anymore. As a result, no one knew whether a counterparty was good for their money and the credit process came to a complete standstill. Now the problem at SVB is a loss on the portfolio of government bonds. There is now no need to doubt the quality of the final debtor. SVB is a special case because that bank had a volatile deposit base and had taken a large interest rate risk. The supervision of that bank has also not earned a beauty prize. Of course, the rise in interest rates and the resulting fall in the value of bonds will affect the banks. However, with adequate risk management, the bank will not run into problems. Moreover, the higher interest rates enable banks to boost their margins even further.
• In my opinion, the US authorities have taken sufficient measures to nip in the bud the crisis that could have followed the collapse of SVB by guaranteeing all deposits, including those not covered by the deposit guarantee system. That creates obvious moral hazard problems, but come on… In addition, the Fed has created a new liquidity facility under which banks can lend paper at face value. I think that's a simple yet brilliant move. In fact, that solves the liquidity problem. If that facility had been there earlier, SVB might also have survived, but things don't change.
• The problem at Credit Suisse is years of mismanagement and an unfortunate statement by the largest shareholder. That is not a system problem at all. Moreover, Credit Suisse has a strong balance sheet and therefore a good chance of surviving all this. The Swiss central bank will also do everything it can to prevent a debacle.
• After the crisis of 2008, the requirements imposed on the solvency and liquidity of banks were tightened considerably. Vice President De Guindos of the ECB also pointed this out. He said European banks' capital positions are strong and liquidity is "robust" and of good quality. According to the ECB, it is also not too bad with the exposure of other banks to Credit Suisse, mainly because it is not concentrated. And finally, the ECB says it has sufficient instruments to deal with unexpected financial instability. In other words, 'we've got this'.
I conclude that we are not facing a financial crisis. At least, certainly not now. I do continue to think that a combination of factors has increased the risks. Go ahead. First, the central banks kept interest rates very low for a very long time, which stimulated debt accumulation. In addition, during the pandemic, they have brought a huge amount of liquidity into the system. And then in 2022, they raised interest rates at a record pace. Then there is no other way than that there is pain somewhere. But the problems at SVB and Credit Suisse remain isolated incidents in my view.
The ECB continues unabated with interest rate hikes
The unrest in the financial sector did not tempt the ECB at its policy meeting this week to reduce the planned interest rate hike, and certainly not to pause. The pre-announced interest rate increase of 50 basis points has therefore come about. However, the ECB has refrained from explicitly announcing further interest rate hikes. In fact, ECB President Lagarde said in the press conference that interest rates will be raised further, but that she is holding back on the unrest. She was completely undecided as to whether the next interest rate hike would be another 50 basis points or 25. Inflation will remain far too high for far too long and there is no prospect of waning underlying dynamics.
US inflation picture is less unfavorable
Inflation in the US fell from 6.4% in January to 6.0% in February. In contrast to Europe, core inflation in the US also fell, albeit narrowly: 5.5% in February from 5.6% in January. As I have often mentioned, rents make up a large part of the US inflation basket, at 34.4% (20.3% for us). The increase in rents increased further in February, to 8.1% (January 7.9%), and thus makes a substantial contribution to total inflation, almost half. Still, optimism is in order here. Rents follow house prices in the US fairly closely, but with a significant lag. Because house prices have been falling for more than half a year, a weakening of the rent increase within a few months is reasonable. Then the overall rate of inflation could clearly fall further.
I doubt, however, that inflation will quickly move towards 2%. To me, the wage increase of about 6% seems much too high to allow inflation to fall smoothly to 2%. So I think we might be stuck somewhere between 3% and 4% later this year unless wage growth slows down. Incidentally, oil and gas prices have fallen sharply recently. That will also help bring inflation down, but an unexpected increase in energy prices later in the year could throw a spanner in the works.
China is taking it easy for now
An increase in energy prices may be caused by an increase in Chinese demand. This can be restarted by the recovery of activity in that country. In December, the zero-covid policy changed quite suddenly and since then the frequent very strict lockdowns have disappeared. The question was, and is, how quickly that activity will bounce back. The answer to that is: there is recovery, but it is not exuberant. Industrial production was 2.4% higher in January-February than a year earlier. That is better than December's 1.3% but lower than expected and, of course, also lower than the 5% the government has set as its target for economic growth this year. You, therefore, do not yet see any price-increasing effect on raw material or international freight prices.
Chinese consumers are also taking it fairly easily. Retail sales in January-February were 3.5% higher than last year. In December it was still -1.8%. And that's in nominal terms too, although it should be noted that Chinese inflation was only 1.0% in February.
Incidentally, these year-on-year percentages will rise very sharply in the coming months, especially in April, because April 2022 was an exceptionally weak month in terms of production and retail sales.
Afsluitend
I do not think we are heading for a financial crisis, although the unrest may well last for a while and there is a chance that new victims will be caught by the rapid rise in interest rates.
US inflation is moving in the right direction and will fall significantly further in the course of this year, but is unlikely to reach the Fed's 2% target anytime soon. The wage increases still seem too strong to me for that. The demise of SVB led to speculation about whether the Fed would pause its rate hikes, but now that they've nipped the crisis in the bud, I think we should expect a rate hike in the coming week. A step of 25 basis points is obvious. After all, at the previous meeting, the Fed had already switched to a 25 basis point increase. Before the SVB crisis, there was some discussion of whether they would return to a step of 50 basis points. So I don't think they will. The Fed will not be very dissatisfied with the latest inflation figures. And while I am optimistic about the outlook for financial stability, a 50 basis point rate hike now seems like an unnecessary risk.
Business in China is slowly picking up again, with an emphasis on slow. For example, the global economy will probably continue to ripple along quietly in the near future.
