Our apologies to The Bard for this week’s title, an admittedly awful take on one of the most famous bits of dialogue penned by the great William Shakespeare — “A rose by any other name would smell as sweet,” as said by Juliet to Romeo in the play Romeo & Juliet. While the quality of our prose might be underwhelming, the point about tightening financial conditions is worth making.
As we know, the Federal Reserve has raised rates nine times over the past year in hopes of bringing down historically high inflation. And as we also know, the way high-interest rates solve for high inflation is they make capital more expensive for consumers and corporations, which in turn slows consumer and corporate spending, which in turn slows the economy, which in turn brings down inflation. Said differently, the Fed is raising rates to tighten financial conditions. But it isn’t just the Fed and higher rates that influence financial conditions. Consumer and corporate sentiment play a part, as does the ability and willingness of banks to extend credit to consumers and companies. This brings us back to the title of this week’s piece.
It would seem the failure of Silicon Valley Bank and the ongoing concerns over the banking system should be thought of as a rate hike by another name that has indeed tightened financial conditions just the same. One way to quantify this is the St. Louis Fed Financial Stress Index which measures the degree of financial stress in the markets — zero represents normal market conditions; values below zero represent below-average market stress and values above zero represent above-average market stress. Well, two weeks ago the Index jumped to 1.6, its highest level since the early days of the pandemic (see chart), while Fed Chair Powell, at his post-FOMC March meeting press conference, said a tightening of financial conditions would work in the same direction as rate tightening. We don’t think the banking system faces systemic risk, but we do think its struggles of late have tightened financial conditions and have increased the risk of an economic recession.