March 10, 2023

This past week Silicon Valley Bank warned that it was having difficulty and needed to issue additional stock to counter losses on its holdings of securities.  That announcement crushed bank stocks and dinged the overall market.  This can happen when the Fed rapidly increases interest rates.  But is this a one-off event, or is the banking system more fragile than previously believed?  The answer to that question is going to depend on the health of the economy.  If growth slows appreciably, the banking difficulties will multiply and soon push the economy into recession.  We do not buy into that scenario.  Clearly growth has slowed but, in our view, the economy is likely to continue expanding at a moderate pace for the rest of the year.  Why?  Because real interest rates remain negative.  Negative real rates are not going to slow growth enough to threaten a recession until much later in this year.  By then the Fed will have, presumably, raised the funds rate from 4.75% currently to the 6.0% mark and real rates will finally have become positive.  That is likely to produce the long-awaited recession in the first half of 2024.  It is coming, but it is unlikely to occur in the absence of further Fed rate hikes.

There can be little difficulty that Silicon Valley Bank is under pressure and there could be at least a few other banks facing similar challenges.  But widespread damage to the banking system does not occur in a negative real rate environment.  The funds rate today is 4.75%.  The core CPI is 5.5%.  The real funds rate is negative by 0.75%.  But  history suggests that the economy does not roll over into recession until that real funds rate has become positive.  Thus, in our view, the Fed still has a ways to go before it needs to worry.  We suspect that the Silicon Valley Bank fears are not the tip of an iceberg, but by the fall of this year the recession concern will be more warranted.

The employment report for February did not reveal any present danger, but it did provide additional evidence that the economy will continue to soften.  Payroll employment rose 311 thousand in February and in the past three months has, on average, climbed by 351 thousand.  In the first three months of last year employment gains averaged 550 thousand.  Hiring has slowed in part because the pace of economic activity has softened,.  However, monthly employment gains of 350 thousand remain robust.

At the same time, as demand softens firms are choosing to work existing employees shorter hours.  The length of the nonfarm workweek has fallen steadily since March of last year.  It declined 0.1 hour in February to 34.5  hours, but that follows a 0.2 increase in January.  Going into the 2020 recession the workweek was at 34.5 hours.  It is really hard to interpret its current level as being indicative of a problem.  Slower growth, yes, but not a recession.

The unemployment rate rose 0.2% in February to 3.6%, but it is important to remember that it surprisingly declined 0.1% in both December and January.  It has been hovering around this same level for a year.

Having said all this, the employment report continued to raise warning flags.  Average  hourly earnings have risen 4.6% in the past year which in normal times would be a healthy gain.  But in today’s world when inflation has surged by 6.5%, real earnings have fallen by 1.9%.  Thus, consumer purchasing power has been shrinking.   If a consumer goes to the grocery store today and spends $100, he or she might walk away with four bags of groceries.  But a year ago they might have been able to leave with five bags.

To counter the reduced purchasing power consumers have been relying on credit cards to maintain their pace of spending.  In the past year outstanding credit card balances have risen by 15%.  That is obviously very rapid and not sustainable.

But, thus far, it is not a problem because the consumer had so little debt initially.  It appears that consumers used at least some of the stimulus checks handed out in 2020 and 2021 to pay down debt.  As a result, monthly financial obligations as a percent of income fell to its lowest level since the 1980’s.  The current credit card binge has boosted that debt ratio, but it remains far below its average for the past 20 years.  While consumers may not be able to rely on their credit cards forever, they do not seem in danger of being constrained any time soon.

All of this suggests that while the economic outlook has deteriorated in the past year given the extent of Fed tightening, it is not on the cusp of entering a recession.  To make that happen the Fed needs to push the funds rate higher to, perhaps, the 6.0% mark by the fall.  If, as expected, the core CPI slows to 4.6% by that time, the real funds rate will be positive at 1.4%.  That may be high enough to push the economy into a mild recession in the first quarter of next year.

We will need to worry about a recession at some point.  But not yet.

Stephen D. Slifer


Charleston, S.C.