MNI INTERVIEW: Financial Stress Could Be In Early Stage-Hoenig

The collapse of Silicon Valley Bank likely marks the start of a broader period of financial turmoil that could convince the Federal Reserve to cut rates before year end, former Kansas City Fed President Thomas Hoenig told MNI.

“In one sense we’re in the early stages because the interest rates have risen and it takes a while for that to have its effect,” said Hoenig, who is also ex-FDIC vice chair.

He said the Fed’s quarter point interest rate hike this week was a largely symbolic move aimed at reassuring markets that the central bank was not reversing course in a panic. However, Chair Powell has all but telegraphed an end to rate hikes at the next meeting in May.

“They did what was expected of them and then allowed themselves all the room in the world to stop at this and probably not move in May,” he said. “The big test for them will be how much volatility the banking industry and the financial system shows between now and then.”

Fed officials are hoping they don't have to cut interest rates this year as inflation pressures remain high but they may be corralled into easing anyway if a credit crunch hits the economy.

"The thing that would cause them to have to cut rates is financial instability. And the thing that would make that even more complicated is if the inflation reignites or fails to fall at all."

The FOMC will also likely have to abandon its plans to shrink the balance sheet, Hoenig said. “I cannot fathom them shrinking their balance sheet – this will end it. That will be their first ‘easy’ move.” (See MNI INTERVIEW: 'Most Dovish Hike' Shows Fed Likely Done-Swonk)

CRISIS LAGS

Hoenig said the long and variable lags associated with the effects of monetary tightening on the economy apply to financial markets as well, pointing to developments during the 2008 global financial crisis.

“From the time they started raising interest rates to when we had a major financial and economic crisis was four years. That’s what makes you think maybe this is actually just beginning,” he said.

The global banking system has come under pressure this month as the failure of Silicon Valley Bank kickstarted broader concerns about unrealized losses on the balance sheets of other institutions. There were also worries about some European banks, with the shares of Deutsche Bank under pressure Friday just a week after the last-minute purchase by UBS of Credit Suisse.

“The entire banking system, $23 trillion has two kinds of risk that only becomes sharper when you raise interest rates by a factor of more than 20 in a year’s time, and that is all assets suffer from duration risk because interest rates have gone up and I don’t know how many of those assets are fixed,” Hoenig said.

“Then there’s credit risk – as interest rates rise, cash flows become more difficult to meet, the requirements become more difficult to meet and incomes are not growing as rapidly and the economy is slowing like in commercial real estate. Those are just getting off the ground. We’ll have to get through that, that will be difficult.”