Powell Speak: Financial Stability and Macro Developments

30 Jun 2023 , 12:16 PM

Speaking at the Fourth Banco de Espana Conference on Financial Stability, Madrid, Spain; Jerome Powell spoke at length about financial stability in the US context and other macro developments and how the Fed was tackling them. 

Ten important points on financial stability made by Jerome Powell

Addressing the Conference on Financial Stability at Madrid, Powell dwelt at length on the US economy, the slowdown in growth, inflation and how the Fed was trying to balance these diverse agendas. Here is what Powell said.

1. In the year 2022 and the first quarter of 2023, US GDP growth slowed and the pressure looks set to continue in the second quarter of 2023 also. However, the growth in consumer spending picked up, while housing activity stayed well below its peak levels seen in early part of 2022. This is a direct outcome of higher mortgage rates. Apart from interest rates impacting housing, it has also weighed on fixed business investments.

    

2. One of the standout features of the US economy in the last year and half has bene the inordinately tight labour market. That has continued. Even in the latest quarter, payroll job gains have been robust. Despite unemployment rate moving up to 3.7%, it is much lower than the average historical levels. It is only when there is greater balance between demand and supply that one can expect easing in nominal wage growth. For now, the labour market remains grossly under-supplied. 

    

3. One of the concerns for the Federal Reserve has been that inflation has stayed well above the longer-run goal of 2%. Consumer inflation for May fell to 4%, but is still 200 bps away from the target. If one looks at the more pragmatic personal consumption expenditures (PCE) inflation, even that is averaging around 3.9%. However, if one looks at core PCE inflation (excluding food and fuel), it is closer to 4.7%. Inflation has moderate, but still has a long way to fall.

    

4. Since March 2022, the Fed had raised the policy rate by 500 basis points from a level of 0.00%-0.25% to a level of 5.00%-5.25%. According to Powell, the tightening has had a sobering impact on inflation, although the actual lag effect on inflation could continue much longer. The impact of the higher rates is most visible in the most interest rate–sensitive sectors of the economy like housing and investment. One thing the Fed has been continuously monitoring is whether the high rates are having any undesirable effect on the growth engine of the US economy.

    

5. While it may be early to talk about recession, the fact is that the US economy was facing headwinds from tighter credit conditions for households and businesses. These are likely to have repercussions for economic activity, hiring, and inflation. The credit conditions have become tighter in the US due to a combination of higher rates and the evolving banking crisis among small and mid-sized banks. While the Fed is non-committal on the terminal rate level, members of the FOMC have underlined the risks of recession consistently in previous meetings. However, the Fed is not done with hawkishness.

    

6. Powell spoke at length on how the Fed and the US government had handled banking stress. They had immediately enabled Federal Deposit Insurance Corporation to resolve two failed banks in a manner that protected 100% of the depositors. That was needed to restore trust in banking system. Also, the Fed and the government immediately made liquidity taps available for stressed banks to fall back upon. He underlined that deposit flows remained resilient even after the crisis. 

    

7. Providing a historical perspective, Powell added in his speech that the banking system in the US had become stronger with each crisis; starting with the great recession of 1933. The last banking crisis about 15 years was the global financial crisis of 2008, which followed the collapse of Bear Sterns and Lehman Brothers. The government had sunk in $700 billion via the TARP program and also expanded its bond book to infuse liquidity. This process was repeated in the COVID pandemic in 2020 and at that point, the liquidity infusion had taken the Fed bond book to well above $9 trillion. 

    

8. Powell underlined that through all these major crises, the one underlying theme was to protect and strengthen the banking system. In the last 35 years, the banking system was made more robust through capital adequacy, liquidity requirements, stress testing, asset quality monitoring etc. The stress tests are a regular feature wherein the banks are tested for adequacy of capital in a worst case scenario. Powell also made an interesting point that banking and financial system resilience cannot be taken for granted. For instance, the Russian invasion of Ukraine triggered a surge in oil prices and global inflation. This led to higher interest rates, pushing a number of banks and non-banks to the point of extreme stress. 

    

9. On the subject of banking stress, Powell has made 3 very interesting observations. The first observation is that it is difficult to resist the natural human tendency to fight the last war. For example, Lehman was a classic case of unsustainable credit loss risk while SVB was a case of interest rate risk managed badly. The answer, according to Powell, lies in strengthening supervision and regulation of institutions of all sizes, without impacting innovation and growth. Secondly, Powell observed that the key was to recognize a crisis in advance and nip it in the bud. For instance, in the case of SVB, the run on deposits happened immediately and did not take as long as the Fed imagined. Thirdly, Powell pointed out that it was good that the large and systematically important banks (SIB) were well capitalized as they could bail out stressed banks. However, the key is to arrive at a middle path. How to ensure orderly growth of mid-sized banks with supervision but without impacting innovation.
    

Finally, Powell underlined the need for greater cooperation in central banking policy in an interconnected world. We saw during the global financial crisis of 2008 how quickly a crisis can get transmitted across the world. In anything, the global markets have only become a lot more interconnected in the last 15 years. The need of the hour is not only to avoid too much of monetary divergence, but also to ensure that monetary policies are formulated more in sync and cooperation with other global regulators.