Liquidity: it’s dangerous going down

Geographically, the implications are most significant for the United States. Duration risk is inherent in financial services systems - banks hold deposits which can generally be withdrawn at short notice but lend that money for longer terms.

“The first substantial stresses have now manifested, and ANZ Research expects more to come, as policymakers balance short-term stability considerations and with longer-term inflation impacts.”

Ultimately confidence and trust are required for system stability. There are a range of reasons to think the worst outcomes are far from the most likely. Notably, the 2008 global financial crisis is still a fresh memory and policymakers are being highly responsive to individual bank issues as they arise.

To the degree it can, monetary policy is responding to what are, so far, localised issues. While several central banks have hiked recently - and ANZ Research expect further rises over coming months - the risks around banking sectors are acknowledged and forward guidance has become less hawkish.

The pockets of financial stress seem much narrower than during the GFC. BIS data suggest this has been the least credit-intensive US upswing in four decades. Regulation also tightened substantially following the GFC and bank capital levels are much higher.

Finally, household sector balance sheets are in much better shape across a range of markets including the US, Australia, New Zealand and Korea.

It is different this time.

Lowering inflation - from the 7 to 8 per cent many economies have experienced - to central bank targets of between 2 and 3 per cent was always likely to come with some stress, even if identifying the form and the timing was difficult.

Central banks need to lower demand to a level better balanced with supply. The idea inflation would simply evaporate didn’t seem well-founded. The first substantial stresses have now manifested, and ANZ Research expects more to come, as policymakers balance short-term stability considerations with longer-term inflation impacts.

As such, despite resilience, ANZ Research expects recent banking events to crystallise a trend of tighter $US liquidity and consequently greater sensitivity to further interest rate hikes.

Coming into this period credit conditions were already tightening. Data show commercial lending growth slowing and US money supply falling. The US Federal Reserve’s January 2023 Senior Officer Loan Survey indicates a net balance of 45 per cent of US banks were tightening standards for commercial and industrial lending. This level of tightening has historically been associated with recessionary, or near recessionary, conditions.

In February, a near record 56 per cent of households said credit availability is worse than one year ago. Both lenders and depositors have likely become more cautious after recent developments which will tighten credit conditions further.

Recent events haven’t affected conditions outside the US to the same degree. Policymakers have acted thus far to ensure few direct spillovers, excesses in emerging markets don’t seem to be as prevalent, and commentators suggest bank regulations outside the US have been enforced more stringently.

In ANZ Research’s view, policymakers will need to remain very active in the face of any further instability in individual institutions and for those policy actions to ultimately bring a halt to further problems.

Our view of a global slowdown but not a crisis requires policymakers to remain very active in the face of any further instability in individual institutions and for those policy actions to ultimately bring a halt to further problems.

In the GFC, inflation was low and central banks could consequently reduce interest rates as required. With inflation high at present, central banks are constrained in their ability to respond to stress.

ANZ Research’s view also requires central banks to continue with the challenge of balancing both financial stability and price stability. The policy response to deal with the financial problems of today is to add more liquidity, even if only targeted to certain institutions.

But if policymakers are successful there is at least some prospect this compounds the inflation challenges of tomorrow.

Richard Yetsenga is Chief Economist at ANZ

This piece originally appeared in ANZ Insights published on 31 March 2023