Yesterday the Federal Reserve (Fed) raised its policy rate by a quarter-point and signaled that the central bank was open to pausing rate hikes sooner rather than later. And while just a month ago it seemed like policymakers were going to keep interest rates higher for longer, the fact is that a lot has changed in the past few weeks.

Indeed, given the events unfolding with the likes of Silicon Valley Bank, Silvergate, First Republic, Credit Suisse and others, it’s quite possible to say that the Fed has met its objective to cause “pain” as systemic concerns and the risk of recession are all but assured in the current economic environment.

So, what’s changed in the past couple of weeks to cause such an about face with respect to the interest rate outlook for 2023? Certainly, just a month ago we were expecting higher rates for longer throughout the course of this year.

Even so, what’s likely changed the rate calculus is what could be the beginning of a credit crunch-induced economic recession.

Now, you’ll likely recall that Fed Chair Jerome Powell drove home the point of bringing economic “pain” during his comments at the Jackson Hole Economic Symposium last summer. Back then, the Fed had aggressively raised interest rates and the markets were hoping that the velocity with which policy was implemented at the time would usher in a rate pause from the central bank.

Nevertheless, with consumer spending and the jobs market still strong, it was clear that the fight against inflation was not over. In a sense, policymakers were desperately trying to jawbone, or talk down the economy, in a bid to get inflation under control. Even so, the Fed ended up raising interest rates another 9 times, leading to one of its quickest periods of rate hikes than we’ve seen in recent history.

With that said, the trouble with the Fed’s policy was that no matter how much it communicated how high rates might need to go, demand in the economy remained solid. That’s because household spending shifted from stimulus checks and tax credits in the years following the pandemic, to charging up credit cards and borrowing against their homes to spend more, which caused inflation to largely remain unchecked.

Indeed, government data show that in 2022, total household debt rose by a full trillion dollars as individuals charged up credit cards and used their homes as ATM machines in full force. What this suggested to many observers was that households were less sensitive to higher borrowing costs than some policymakers had predicted, and potentially pointing to a tough road ahead for the fight against inflation.

And so, with markets rallying into the start of 2023 on an expectation that rates would have to fall, but inflationary pressures nevertheless remaining stubbornly high, central bank officials doubled-down on their “higher-for-longer” narrative. 

That is, however, until the events over the past few weeks finally gave policymakers the “pain” they were looking for that could finally subdue stubbornly high inflation as the risk of a recession becomes more all the more palpable.

Crisis of Confidence

Now, it’s important to recall that for the past year many economists have been saying that a recession has been in the making and could arrive sooner rather than later. Nevertheless, household spending has been generally solid and the labor market conditions have been robust. And, as we pointed out earlier, a key factor contributing to the resilience of the US economy has been consumer’s ability to borrow money to keep up with spending and inflation.

But now, with fissures forming in the broader banking system, it’s very well possible that an individual’s ability to borrow and spend could come to a rapid end as many banks today aren’t willing to lend even to themselves.

Indeed, the issues facing Silicon Valley Bank, Silvergate, First Republic Bank and others not only led to a run on these banks by their very own depositors, it’s once again leading to a crisis of confidence among the banks themselves, and setting the stage for a broader interbank lending freeze.

And why does the interbank lending system matter to the average individual?

Well, interbank lending is when banks share money with each other for a short time. This approach helps financial institutions to have enough money to do their daily jobs, like giving people their money when they ask for it.

And when banks need to quickly tap into cash, they’ll often share their own reserves with each other through the interbank market. This is like a big meeting where banks talk and decide who will lend money and who will borrow it. Sometimes, banks use a special way to share money called a “repurchase agreement.” It’s like borrowing money from a friend with a promise to pay them back later with a little extra on the side.

Now, during times of heightened uncertainty, these borrowing agreements between banks seize up as healthier banks hoard liquidity to mitigate their own risks of depositor flight.

And when this happens, central banks step in to help ensure that financial institutions have enough money so that they can meet their daily demands, which makes central banks the, “lender of last resort.”

Now, you’ll likely recall that during the height of the Global Financial Crisis in 2008, the Fed stepped in as the lender of last resort as credit markets froze up following the collapse of Lehman Brothers.

And today, following the failure of Silicon Valley Bank, the Fed stepped in with another set of measures to restore normal functioning to the financial system, including important changes to how the Fed’s discount window works and the introduction of the Bank Term Funding Program (BTFP).

Bank Crisis: Credit Crunch a Silver Lining for Inflation

With all this said, it’s critical to note that while issues in the interbank lending channels likely won’t spark a Great Depression type slowdown, a sharp decline in lending conditions has the potential to lead to a sudden economic deceleration that could put a damper on inflation overall.

And by now, you’re likely asking yourself, “haven’t we been talking about a recession for the past year, what’s different this time?”

Well, as we mentioned earlier, for the past year, the Fed has been trying to “talk” the economy into a recession. Indeed, policymakers have been vocal in their threats to aggressively raise interest rates so long as households keep spending, businesses keep hiring and prices keep moving higher.

And rather than talking the economy into a recession, policymakers have raised rates to a point where it has caused something to finally break in the financial system, which could likely give way to a credit crunch as the likeliest route to the long-awaited economic downturn.

So, how does what’s going on with the banks affect the broader economy and inflation itself?

Well, if banks are less willing to lend to each other, then they’ll likely be less willing to lend to you and your employer. This is what we call a credit crunch. And it’s one reason why, during the Global Financial Crisis, and again this month, that central bankers introduced several measures to return the financial system to regular operations in an effort to avoid what could be a severe economic downturn.

That’s because in response to increased credit risk and heightened uncertainty, banks may become more cautious in their lending practices. This means that as they tighten their credit standards, it makes it more difficult for borrowers, including other banks, to access credit. As a result, as interbank uncertainties persist, overall supply of credit in the economy could begin to dwindle.

And as credit becomes less accessible, businesses and households may cut back on borrowing and spending, leading to a decline in overall economic activity. As this happens, confidence tends to diminish, leading to lower overall spending and investment. And this decline in economic activity can result in lower revenues for businesses, ultimately leading to layoffs and cost-cutting measures. And, when unemployment rises, households have less income to spend, further exacerbating the decline in demand.

So, how does this play into the fight against inflation?

Well, as demand falls, businesses may lower their prices as a way to attract customers and maintain sales volumes. This can contribute to deflation, as the general price level of goods and services in the economy decreases. Indeed, a recession can lead to lower inflation (or outright deflation) through a combination of factors, including lower aggregate demand, tighter credit conditions, and a decline in interbank lending. And when left unchecked, these factors interact in a feedback loop, reinforcing the downward pressure on prices and economic activity.

A Silver Lining Supportive of Risk Assets

So then, from a markets perspective, what does this potentially negative economic outlook mean for risk assets this year? Well, where the markets go from here likely all comes down to the Fed’s rate policies.

That’s because if the Fed has finally caused the pain that it has been seeking for so long, then the recent events in the banking sector likely suggest that the Fed has less of an incentive to continue pushing rates higher from here.

Indeed, the key risk now is that policymakers overtighten, creating a deflationary environment that could be worse than the inflationary one they’ve been fighting for the past year.

That’s why after this week’s meeting, markets are pricing in rate cuts by July, and speculating that the credit crunch likely already underway will be enough to not only curtail inflation, but ultimately lead to an economic downturn that finally forces the Fed to “pivot” as so many market participants have been waiting over the past year.

And while this perspective might make getting back into the markets attractive at this point in time, there are several reasons for investors to remain cautious in the current environment.

First, it’s not yet clear yet whether we’ve seen the end of stresses in the global financial system. While the factors contributing to Silicon Valley Bank can be attributed to poor risk management, a crisis of confidence ultimately sparked its demise and triggered troubles for other flagging banks.

Second, while it’s possible that a credit crunch could be the answer to the Fed’s inflation problem, only time will tell whether the inflation fight is largely over. Indeed, policymakers are walking a fine line between preserving systemic stability, and taming inflationary pressures. That’s why incoming data over the next couple of months will be crucial to determining how much leeway policymakers have to cut rates as growth slows.

Finally, even if inflationary pressures finally appear to be under control, there’s a risk that stocks likely won’t move higher in a straight line. Indeed, in the months following the collapse of Lehman Brothers and the introduction of government rescue programs, the markets continued to sell off sharply before finding their footing and setting the stage for a broad bull market rally.

That’s why as you’re looking over the current environment and considering your investment decisions, your most prudent choice likely will be to avoid market timing and stick with your long-term disciplined investment strategy.

That’s because accurately predicting the direction of the market is inherently challenging due to the multitude of factors that influence market movements. These factors can include macroeconomic indicators, policy changes, corporate earnings, geopolitical events, and investor sentiment. And the complex interplay of these factors makes it nearly impossible for investors to consistently predict the optimal entry and exit points in the market.

What’s more, market timing often relies on emotional decision-making, which can lead to irrational behavior. That’s because when market volatility is high, fear and greed could drive you to make impulsive decisions, such as selling assets during sharp declines or buying during periods of rapid appreciation. Such decisions are often driven by short-term market fluctuations rather than a long-term investment strategy, which can result in suboptimal outcomes, especially if the risks we mentioned earlier come to the foreground.

Ultimately, it’s essential to remember that some of the best days in the market have occurred during periods of high volatility, and missing out on these opportunities can have a detrimental impact on long-term investment performance.

That’s why focusing on the most crucial aspects of investing, such as proper asset allocation, portfolio diversification, and long-term investment planning can help mitigate unnecessary financial risks and improve your chances of mastering your path to financial independence.