What's different this time is that global financial stress -- which has its genesis in four policy choices made in recent years -- is juxtaposed with a more resilient real economy, observes Sajjid Z Chinoy, chief India economist at J P Morgan.
The global economy is currently riddled with contradictions. One part is well-known.
That some financial institutions are under stress across both sides of the Atlantic, reflecting both idiosyncratic factors (inadequate risk management, failed restructurings) and systemic pressures (the sharp rise in interest rates over the last year coupled with loosening of regulations for mid-sized banks in the US).
Frankly, that stress would emerge somewhere in the system was inevitable on the back of the most aggressive and synchronised global monetary tightening in four decades.
Something somewhere was bound to eventually break.
The question always was, where, and more pertinently, would it bring the system down with it?
Thus far, regulators have jumped in aggressively to ring-fence islands of stress, provide generous regulatory and liquidity support, although risking moral hazard in the process.
The idea to move quickly and expansively is understandable given worries about financial contagion and non-linear outcomes.
But niggling concerns still remain.
Is financial stress going to spread?
Are US regional banks the canary in the coalmine?
Where are the other vulnerabilities?
What's less appreciated, however, is the resilient global economic backdrop against which this is playing out.
US labour markets remain red hot, having added another 800,000 jobs the last two months, helping power US household consumption to an above-trend 4 per cent this quarter.
Consequently, US growth is again tracking a healthy 2.5 per cent this quarter and global growth is tracking 3.5 per cent -- a full percentage point above trend.
While some of this is undoubtedly on account of the China re-opening, even without China, global growth has actually accelerated into 2023.
Where's the much-anticipated slowdown?
Therein lies the contradiction.
Typically, financial stress is a manifestation of underlying economic weaknesses, imbalances and vulnerabilities in the real economy: Excessive private sector leverage, a sharp fall-off in growth or prices, worsening corporate health.
But this time is different. Financial sector stress is juxtaposed with economic resilience.
So how did we get here? How will the contradiction resolve? And what does the future hold?
The combination of a resilient private sector, very tight labour markets, uncomfortably-elevated core inflation, a very rapid increase in interest rates, and financial stress in the US has its genesis in four policy choices exercised in recent years.
Two of these pre-dated the pandemic: Tightening immigration policies that resulted in a negative supply shock to US labour markets, and loosening Dodd-Frank regulations for mid-sized banks in 2018 that reduced the regulatory oversight for banks like Silicon Valley Bank.
The remaining two policy choices were in response to the pandemic: A gargantuan fiscal stimulus and very delayed commencement of monetary normalisation.
How did these choices interact with each other?
The outsized fiscal stimulus fuelled strong aggregate demand.
But the supply side struggled, because of supply-chain disruption from the pandemic and the Russia-Ukraine war.
On its part, the labour market suffered from deaths, older workers withdrawing from the labour force, younger workers returning only slowly because of hefty fiscal transfers, all of which was accentuated by the secular tightening of immigration laws that prevented foreign workers from filling the gap.
The consequence of strong demand and multiple supply shocks: Inflation surged.
The Fed looked the other way through all of 2021, realised it was badly behind the curve in 2022, and then hiked by 450 basis points in a year.
This quantum of tightening in just a year was bound to create stress somewhere.
Bond prices fell as interest rates rose, causing bond losses for banks such as Silicon Valley Bank that hadn't managed their interest rate risk well.
The fact that trouble surfaced in mid-sized banks is no coincidence, given the loosening of oversight and regulation on these banks after Dodd-Frank regulations were eased in 2018.
More generally, the Federal Deposit Insurance Corporation estimates there are about $620 billion of unrealised bond losses on US bank balance sheets.
In response, central banks and regulators have jumped in aggressively to bail out uninsured depositors and provide liquidity at very generous terms.
To be fair, faced with this 'hostage-like' situation of bank runs and financial contagion, central banks had little option but to intervene decisively.
Moral hazard is likely to emanate.
But the original sin was the aforementioned policy choices that led to being taken hostage in the first place.
So where to from here? Central banks will need to simultaneously achieve two objectives: Bring down inflation (which is still very elevated with US and Euro area core inflation tracking an annualised momentum of 5.2 per cent and 6.4 per cent, respectively, over the last three months), but simultaneously preserve financial stability.
In the spirit of the Tinbergen Principle, two objectives will require two instruments: Deploying interest rates for aggregate demand and inflation while using regulatory interventions, supervisory oversight and lender-of-last resort liquidity backstops -- of the kind used in recent days -- to avoid financial contagion.
One could argue the expansive and generous bailout last week was precisely to create a strong ring-fence around the financial sector, to enable the Fed to continue raising interest rates and quell inflation.
But the 'separation principle' is easier said than done, and how things pan out from here will depend crucially on how financial stress interacts with economic resilience. One can envisage three different scenarios:
First, bailouts and liquidity notwithstanding, credit conditions will inevitably tighten in advanced economies.
Quite apart from the cost of capital, the availability of capital/deposits is likely to become a challenge for peripheral banks and borrowers, as the system undergoes a 'flight to safety'.
This, in conjunction with increased regulatory oversight in the US, is likely to drive tighter lending standards, increase risk aversion among banks and weaker credit growth.
As long as things don't over-correct, this may actually help the Fed's cause.
The market will be doing some of the Fed's work on monetary transmission to help slow aggregate demand and help dis-inflate.
The implication: A financial crisis is averted and the Fed may not have to raise interest rates as much as was previously feared.
To be sure, rates will still go up and the US is still likely to end up in recession, but perhaps not the hard landing envisaged if policy rates had gone up to 6 per cent and beyond.
A second, more ominous, possibility is that the damage has already been done in the financial sector.
A crisis-of-confidence has set in, financial stress will only build from here, and will eventually expose the weaker links in the chain, especially outside the banking system of which much less is known.
The implication: Growing financial stress bordering on a crisis will push the real economy into a near-term recession of unknown magnitude.
A third possibility, on the other end of the spectrum, is that events of the last week are a storm in a teacup.
The stress in mid-sized banks is idiosyncratic and the generous protective liquidity cover will insulate the broader US economy from recent events, while the Swiss merger will eventually calm nerves in Europe.
Consequently, the impact on the real economy will be more muted and inflation will continue to be a concern.
In this scenario, the Fed will have to keep going, albeit in small increments, to a higher terminal rate than currently thought of.
The implication: A hard landing is still necessary to bring inflation down to targeted levels, with associated financial instability risks in the future.
A case of not being able to make an omelette without breaking the egg.
Which of these scenarios plays out is the known unknown of the moment, but will have crucial implications for the outlook.
It's the difference between the global economy bending and breaking. Fasten your seatbelts and brace for landing.