How the bank mess could push inflation lower

Lenders worried about withdrawals may make loans harder to get, which would have the same impact as a rate hike

The Marriner S. Eccles Federal Reserve building in Washington, DC, on March 13, 2023.Al Drago/Bloomberg

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The Federal Reserve raised interest rates on Wednesday for the ninth straight time in an effort to contain the worst inflation since the early 1980s.

But after a full year of rate hikes — intended to tamp down the strong consumer spending and business investment that are driving up prices — inflation continues to run at two to three times the central bank’s 2 percent target.

The Fed’s latest increase — a quarter of a percentage point, to a range of 4.75 to 5 percent — came as recent bank failures, a surge in deposit withdrawals, and tumbling bank stocks have undermined confidence in the US financial system.

But the banking turmoil could actually help push inflation lower, with Fed chair Jerome Powell telling reporters after the decision that the central bank may not have to boost rates as much as previously planned. If lenders worried about a run on deposits make loans harder to get, so they have a bigger capital cushion, that would slow demand.

”You can think of it as being the equivalent of a [quarter-point] rate hike or perhaps more than that,” Powell said.

To understand this dynamic better, I reached out with questions to Michael Klein, an economics professor at the Fletcher School at Tufts University who is the founder of EconoFact, a nonpartisan website that does an excellent job explaining economic issues.

Here’s what he had to say.

What exactly does the Fed mean when it says the recent bank failures and declines in bank stocks “are likely to result in tighter credit conditions for households and businesses”?

Klein: Bank management may well feel that they need a bigger cushion to protect them from the possibility of bank runs or their own financing drying up. The cushion is provided by making fewer loans because money that is loaned out is not immediately accessible the way cash-on-hand or other types of securities, like Treasury bills, can be quickly converted to cash to meet withdrawals.

How will tighter credit, using the Fed’s words again, “weigh on economic activity, hiring, and inflation”?

Klein: Many companies, especially smaller ones that do not have access to national bond markets or that cannot float stock, depend upon financing from banks. If banks limit lending this will make it more difficult for companies to borrow and, therefore, to finance business expansion, investment, etc. . . . This type of “credit crunch” hurt the New England economy in the early 1990s.

Most banks are not seeing unusually high deposit withdrawals. Why would they scale back lending?

Klein: Even if they are not seeing withdrawals now there is a concern that there could be a bank run. The fact that the Fed and Treasury decided to back depositors, even those with more than $250,000 in deposits (which exceeded the FDIC limit), probably helped a lot to stem withdrawals.

What kind of consumer loans would be most affected by a bank’s decision to make fewer loans?

Klein: I would think the banks would cut back on loans that are held by them and not sold off in a secondary market (as mortgages are), loans that are of longer duration, and loans that are seen as most risky (perhaps because there is not really good collateral that can be seized and easily sold in the case that the loan becomes non-performing).

Finally, why has inflation proven so difficult to get under control?

Klein: Good question! There were at least two massive supply shocks (pandemic and supply chains, followed by the war in Ukraine) and also a lot of [government financial] support of demand to keep the economy from cratering at the time of the pandemic — recall how unemployment spiked in spring 2020. There does not seem to be a wage-price spiral going on. I did an interview with Jeff Fuhrer for the EconoFact podcast series, and Jeff is optimistic that inflation will come down. But it won’t spike down the way it spiked up — there is an asymmetry there.