Prof. Cam Harvey's Analysis on the 2023 Banking Crisis

If you see three cockroaches (leading to $500b in bank failures), how many are behind the wall? The Fed is in a lose-lose situation, but after Wednesday’s rate hike we may soon see more roaches.

The Fed is playing a complex game. On Wednesday the Fed could have played the game one of two ways:
1. Pause: This option may have been interpreted as evidence the health of the banking system is worse than currently believed and could have caused a panic.
2. Hike: This option (which it chose) can increase stress on the financial system, heightening the probability of a hard landing.

Both are losing hands.

It is naïve to think the banking problem is a three-bank problem. An alternative strategy is to show the public a data-driven risk analysis of US banks. Many regional banks are getting hammered – perhaps some unfairly. Which one is next? Why be so opaque? The heightened uncertainty is increasing the risk of a contagious event.

Let’s put all the cards on the table

Given the Fed’s own admission of failing supervision of SVB, I hope the Fed changes tactics.

The Fed’s recent record is quite disturbing

1. The Fed kept rates near zero during a period of robust economic growth, low unemployment, and record-high stock prices inducing individuals and institutions to “reach for yield” (e.g., SVB) and take on additional risk.

2. The Fed tried to talk down inflation as temporary when it was obvious to key observers it was anything but temporary. The strategy seemed to be aimed at tempering expectations. Assessments based on data rather than attempting to mislead to achieve a goal are far preferable.

3. The Fed is now trying to correct its earlier mistake (not hiking early enough) with another mistake (not pausing early enough). In economics, two negative actions do not equal a positive.

4. The Fed is not being transparent about the current state of the banking system. Fed actions have inverted the yield curve, greatly increasing the risk of a duration event for banks. The Fed also appears not to be performing its supervisory duties — at least that’s how I read the reports on the SVB failure.

   Another roach will appear soon

   It is naïve to think JPMorgan can step in again like it did for First Republic.
   
   I also see two related risks: first, the zombification of part of the banking system, and second, a potential crash in commercial real estate, which is suffering from the structural problem of work-from-home decreasing office demand and from higher rates.
   
   On the positive side, it does look like the Fed will now pause, but unfortunately, five months too late. The damage is done. Inflation over the last nine months has been running at only 3.2%. The key component driving inflation—shelter—is now trending down as both home prices and rents fall, but will take a while to work through the CPI. This was foreseeable in January. It is now May. I hope we avoid a hard landing, but the Fed has (unnecessarily) made this outcome more likely.