A difficult job becomes even more difficult
Chief Economist Eugenio J. Alemán discusses current economic conditions.
Monetary policy, ever difficult to conduct, became even more difficult over the last week as one of the most difficult processes in banking came to fruition for one bank and brought down another bank in the process: a bank run on deposits.
The lessons the U.S. government and the banking industry learned during the Great Depression helped create the Federal Deposit Insurance Corporation (1933), which instituted insurance on banking sector deposits. Insurance on deposits went from $2,500 back in 1933 to $250,000 today.
It seems that one of the biggest issues for SVB was that a large percentage of depositors were not covered by FDIC deposit insurance. That is, it seems that SVB took deposits mostly from businesses and then invested in longer term, in very safe, but low yielding government securities. As interest started to increase, it seems that customers started to shop around for higher interest rates on their deposits and the bank was unable to stop the bleeding. As customers took their money out, the bank had to sell some of those perfectly secure bonds on fire sale and lost a lot of money in the process, approximately $1.8 billion. When the bank tried to issue debt to re-capitalize for those losses, clients, businesses, and investors, instead of helping recapitalize the bank, went elsewhere, and pushed the bank into insolvency/bankruptcy.
While the FDIC and its deposit insurance facility were created to try to reduce and even try to avoid a banking run, the fact of the matter is that at some level, it is very difficult to completely prevent a run if trust in that bank is lost. The only alternative if this happens is that the central bank acts as “lender of last resort.”
Preventing runs against the banking system does not create moral hazard
Being the “lender of last resort” is the role of the Fed and one of the ultimate reasons for the existence of a central bank. And the Fed fulfilled its role over the last weekend, by taking over SVB and stopping a banking run could have threatened other banks. Hopefully, what the Fed did will be enough.
Many are arguing that the Fed created “moral hazard” by saving the depositors at these two banks. Others are arguing that what the Fed did was tantamount to guaranteeing all the deposits of the banking system. We have even read that what the Fed did changed the nature of capitalism, or something of that nature. We respectfully disagree. Investors in those banks will lose their investment while employees and officers at the bank will lose their jobs.
It is clear the Fed understood that backstopping a run against these two banks and “guaranteeing” the deposits was the correct move. This guarantee does not mean that the Fed and the FDIC are, de facto, guaranteeing all the deposits of the system, as we have heard some saying.
That is, what the Fed and other regulators did does not contribute to moral hazard, as many are arguing. According to Investopedia.com “Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.” It furthermore adds, “anytime a party in an agreement does not have to suffer the potential consequences of a risk, the likelihood of a moral hazard increases.”
However, what seems to be misunderstood is that parking your money at a bank, be it an individual or a business, is not a situation that could generate moral hazard. The U.S. Federal Reserve (or any other central bank in any part of the world) needs individuals and firms to park their monies in the banking system so they can conduct monetary policy and have oversight of the financial system. If individuals and firms kept their monies in deposit boxes or under the mattresses, as it happens in many less developed/high inflation countries, it is impossible for the central bank to be successful at its role. That is, monetary policy to help the economy will be even more difficult.
Thus, even though the FDIC insures up to $250,000 for each account and social security number, it fundamentally does this in order to try to prevent runs, which before the establishment of the FDIC were more common than after the creation of the FDIC. Furthermore, the FDIC is funded by the insurance premiums it collects from member banks as well as its own investments in U.S. Treasuries.
However, if runs happen despite deposit insurance, the only way to stop them is to have the Federal Reserve, the FDIC, and other regulators doing what they did over the weekend, which is guaranteeing the deposits of those institutions that suffered the runs. That should be enough to stop a further run against the system. That is, if these actions stop the run and stabilize the system, there will be no need to completely guarantee the deposits at any other financial institution.
The European Central Bank sticks to its hiking plan
Despite the uncertainty surrounding the strength of the financial sector, the European Central Bank (ECB) raised the three key interest rates by an additional 50bps this week, bringing the bank’s main rate to 3%. This is mostly because, in contrast with the U.S., inflation in Europe has been much stickier, with headline inflation still at 8.5% year-over-year in February. Additionally, Core inflation, which excludes volatile categories such as food, energy, alcohol and tobacco, increased in February from 5.3% to 5.6%. After announcing the rate hike, the President of the ECB Christine Lagarde stated that she is still determined in bringing inflation down to the 2% target, and markets are currently pricing in two more 25bps hikes at the May and June meetings.
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Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.
Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.
The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.
Leading Economic Index: The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non- governmental organization, which determines the value of the index from the values of ten key variables
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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.
FHFA House Price Index: The FHFA House Price Index is the nation’s only collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.
Expectations Index: The Expectations Index is a component of the Consumer Confidence Index® (CCI), which is published each month by the Conference Board. The CCI reflects consumers' short-term—that is, six- month—outlook for, and sentiment about, the performance of the overall economy as it affects them.
Present Situation Index: The Present Situation Index is an indicator of consumer sentiment about current business and job market conditions. Combined with the Expectations Index, the Present Situation Index makes up the monthly Consumer Confidence Index.
Pending Home Sales Index: The Pending Home Sales Index (PHS), a leading indicator of housing activity, measures housing contract activity, and is based on signed real estate contracts for existing single-family homes, condos, and co-ops. Because a home goes under contract a month or two before it is sold, the Pending Home Sales Index generally leads Existing-Home Sales by a month or two.
Import Price Index: The import price index measure price changes in goods or services purchased from abroad by
U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).
ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month.ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.
ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.
ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the
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ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.
Source: FactSet, data as of 12/29/2022