In the past week, the Fed lent up to $475 billion to US banks, while an equivalent amount of deposits was withdrawn from the banking system due to the herd effect leading to bank run. Continuing the in-depth macroeconomic analyses from previous articles, this week Viet Hustler will continue to assess the scenario after banking crisis, when inflation concerns may become deflation concerns. The most recent deflation in US economic history caused The Great Depression lasting 10 years (1929-1939).
So why can banking crisis cause deflation? And why must the Fed save the banking system?
Viet Hustler will explain in detail through this week's macroeconomics column.
Latest update on the banking crisis and the Fed's direction
Bank-run continues in the small bank sector
Deposit amounts at US banks continue to decline. In particular, deposits in banks have dropped to nearly -$500 billion in the 2 weeks after the collapse of SVB.
According to the Fed's report, in just the SVB crisis week and the following week, about -$100 billion in deposits disappeared from the banking system. Of which:
Small banks lost: -$119 billion
Foreign banks lost: -$45 billion
However, the top 25 largest banks gained +$67 billion.
=> Bankrun only occurs at small banks.
(Strangely, both SVB & First Republic are in the top 25)
Although large banks are "benefiting", they also won't benefit for long due to the contagion effect happening very quickly in the financial system.
This week, deposits declined in both bank sectors.
In the past week, the Fed lent a total of +$475 billion to US banks to combat the banking crisis.
Of which, small banks borrowed an amount equal to large banks
Loans to large banks: +$250 billion
Loans to small banks: +$250 billion
Loans to foreign banks: +$25 billion.
Also in the past 2 weeks, the Fed's balance sheet (BS) increased by +$392 billion,
The BS value increase in just 2 weeks is equivalent to reversing up to 60% of the previous BS reduction due to QT policy since April 2022.
Where did the withdrawn deposits go?
First, part of the money was transferred from small banks to large banks.
As per the above report, large banks received an additional +$67 billion just in the SVB crisis week.
Large banks benefit from both preferential loans from the Fed and additional depositor money as these depositors "transfer" from small banks.
Naturally, large banks continue to increase lending to businesses:
Total bank loans (bank lendings) increased by +$63.4 billion last week, of which large banks account for 60% of the bank lending value in the market.
However, bankrun is soon spreading to large banks, especially if the Fed continues high interest rate policy due to the substitution effect (analyzed below) ...
Most of the money withdrawn from the banking system was invested in money market (bonds and bills with maturity under 1 year):
Money market funds received an additional +$117 billion in investments last week & +$121 billion the previous week.
What direction for the Fed to resolve the banking crisis?
Most deposits are being withdrawn from the banking system and transferred to money market.
This is completely bad for the economy because the banking system is the funding channel for most small and medium-sized enterprises. Meanwhile, borrowers in the money market are mainly the government (via T-bill) and large enterprises that only need temporary capital.
Deposits being directly invested into money market is quite understandable because money market rates are high at 4.75% with extremely low risk.
Fed funds rate is far ahead of bank deposit rates:
This is a consequence of the Fed raising rates high and quickly, making short-term bond yields higher than other risky assets (as shown by all yield curves being negative).
The only way to stop bankrun is for the Fed to cut rates soon.
Despite Powell's quite hawkish speech last week, the market still bets 92.4% that Fed rates have peaked (Fed will not hike rates in May).
The market even prices in the Fed starting to cut rates in June 2023.
From banking crisis to deflationary effect
As the bank of banks, the Fed's mandatory rescue of the banking system through lending to provide liquidity or bailouts, even accepting to reverse the QT process..., is necessary. So why must the Fed save the banking system?
One of the reasons is that banking crisis can lead to rapid deflationary pressure. Deflation (negative inflation) can harm the economy more than high inflation, through the collapse of the consumer supply-demand structure, which accounts for 70% of GDP.
Economic history: how short is the path from banking crisis to deflation?
Deflation is manifested by rapid price drops, leading to negative GDP growth rates and difficult to reverse for a long time.
When money supply and credit drop suddenly due to bank run while economic output hasn't adjusted downward accordingly, prices of all goods will drop together in a short period.
For example, the 1929-1930 oversupply crisis was also a result of bankrun causing the banking system to collapse (money supply dropped suddenly in the figure below).
Deflation caused the economy to stagnate for a long time: The Great Depression 1929-1939, GDP down -15% and unable to recover steadily throughout 10 years.
One of the reasons leading to The Great Depression was the Fed's failure in its role as bank of banks during the banking crisis that began in the fall of 1930, leading to a money supply drop of nearly -30%.
Deflation originated from the collapse of the banking system, which increased the debt burden on businesses; unemployment increased; consumption collapsed… forcing banks, companies, and individuals to go bankrupt.
For this reason, in any banking crisis since The Great Depression, the Fed must increase the money supply at all costs and save the banking system.
This time will be no exception…
The first signs of current deflationary pressure from banking crisis:
M2 money supply has decreased for the first time since this indicator was primarily used in economic models.
Credit card spending has dropped rapidly, a sign that consumer confidence is declining as they stop consumer borrowing.
Another sign that consumption is declining: refunds are also decreasing.
Banking crisis leads to tighter credit lending conditions even though this situation had already occurred before.
Last week's analysis of Viet Hustler emphasized the credit tightening through raising lending standards from banks.
The number of consumer lending banks is decreasing, especially since most consumer lending or mortgage banks are small banks, which are at the center of the current crisis.
Tightening consumer loans due to banking crisis can also cause inflation to drop rapidly to disinflation, and even deflation. Because consumption accounts for 70% of GDP!
CONCLUSION
Banking crisis is still ongoing in the small bank sector after the SVB event. The Fed's lifeline loans are the only tool maintaining liquidity for these banks. Meanwhile, large banks have benefited somewhat from the Fed's preferential lending program and former customers of small banks last week. However, this week, bank run has started spreading to large banks due to the substitution effect when depositors switch to holding cash in money market with higher yields.
The only way for the Fed to stop bank run due to the substitution effect is to cut interest rates soon. The question is whether the banking system can “wait” until interest rates are cut and money market yields decrease?
At all costs, the Fed must save the banking system, which is the lifeblood of the financial market and the capital regulation channel of the economy. Because the Fed does not want to see the risk of deflation as a consequence of the banking crisis like the Great Depression period 1929-1939. The current deflationary pressure is still ambiguous, but the stagnation of consumption and the tightening of lending conditions by banks are early signs that inflation will quickly decrease, along with the approaching recession.
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