John Maynard Keynes famously said that, “when the facts change, I change my mind. What do you do sir?” It seems that Federal Reserve Chair Jerome Powell does not subscribe to Keynes’s way of thinking.
Even as another US banking crisis now looms and China increasingly poses a deflationary threat to the world economic outlook, Mr. Powell stubbornly clings to the view that interest rates need to remain high for longer to regain inflation control. He also now chooses to phase out the Federal Reserve’s Bank Term Funding Program that was put in place last March to support the banks following the Silicon Valley Bank crisis. This failure to recognize how much the economic outlook is changing for the worse both at home and abroad heightens the risk of a hard US economic landing.
Among the main changes that Mr. Powell chooses to downplay is the banking system’s deteriorating position as a consequence of higher interest rates and of the slow-motion train wreck now underway in the commercial property sector.
According to calculations by my American Enterprise Institute colleague Paul Kupiec, as a result of last year’s interest rate spike, the banking system had accumulated over $1.5 trillion in unrealized mark-to-market interest rate-related losses on its fixed rate securities and loans investments as of September 2023. Those unrealized interest-rate losses have erased more than 70 percent of the total loss absorbing capacity of the banking system’s reported Tier 1 regulatory capital.
The banks’ weakened balance sheet puts them in a poor position to absorb the large loan loss provisions that will almost certainly be needed for their more than $3 trillion in commercial property lending.
In the wake of the Covid pandemic, employers are tolerating their employees working at least part of the week from home while households are increasingly shopping online. This has led to a spike in office vacancy rates to almost 20 percent and to plunging office property prices. According to Morgan Stanley, office property prices are likely to decline by at least 40 percent from their 2022 peak levels. This means that around $1.2 trillion in property losses will need to be absorbed by lenders.
It is estimated that this year more than $900 billion in commercial property loans fall due. It is difficult to see how those loans will be rolled over without major rescheduling. This is especially the case given how much higher interest rates are now than when those loans were originally contracted.
A wave of property loan defaults will be particularly problematic for the regional banks that are a major source of finance for small and medium-sized companies. Commercial property loans constitute around 18 percent of those banks’ overall loan portfolios. A recent National Bureau of Economic Research paper estimates that a wave of commercial property loan defaults could result in the failure of around 385 small and medium-sized banks.
Compounding the economic woes at home is the change for the worse in the economic outlook for China, the world’s second largest economy. There is now every sign that its epic housing and credit market bubble has burst. Home prices are falling, property developers are defaulting on their loans, and troubles are emerging in China’s large shadow banking system. At the same time, investor confidence is eroding as a result of President Xi’s erratic economic management and the country is now experiencing price deflation.
The Powell Fed seems to be ignoring the fact that China’s deteriorating economic outlook is occurring at the same time that major countries like Germany, Japan, and the United Kingdom have all succumbed to recession. This is bound to add to the deflationary pressures that will come in the wake of a domestic banking crisis.
In 2021, the Fed chose to ignore the markedly expansionary fiscal policy stance when it kept flooding the market with liquidity. The net result was a surge in inflation by June 2022 to a multi-decade high of over 9 percent. Today, it seems to be making the opposite mistake of keeping monetary policy tight on the eve of a banking crisis at home and a weakening economic situation abroad. Unfortunately, this raises the risk of a hard economic landing within the next year or so.