Banking, credit conditions 'may be the new risk' for markets amid Fed rate hikes: Economist

Deutsche Bank Securities Chief U.S. Economist Matthew Luzzetti joins Yahoo Finance Live to discuss the decline of PacWest Bank stock amongst the regional banking crisis, inflation, a looming recession, the debt ceiling deadline, and the Fed's decision to raise interest rates.

Video transcript

- And let's stay on the regional banks and the implications of all of this, right, because the FDIC is making this announcement as PacWest shares are down again this morning, down 15%. And they keep being halted for volatility. That's after the bank reported deposits fell over 9% last week.

Joining us now for more on the financial sector and really what the economic implications are is Matthew Luzzetti, Deutsche Bank Securities chief US economist. Matt, it's good to see you. And I know we're going to talk more broadly about the Fed and the economy.

But I have to ask you about the banks here and what the implications of what seems to be continuing issues are going to be. I mean, we know it's going to crimp lending, right? I guess the challenge is quantifying that.

MATTHEW LUZZETTI: Yeah, I think it's hugely important for thinking about the Federal Reserve, whether or not they raise rates again this year. It's hugely important for thinking about an economic downturn and potential recession risks. We saw early in the week, we got the Fed Senior Loan Officer Survey that showed that banks continue to tighten lending standards, maybe not as much as feared on businesses, but certainly on commercial real estate. We saw demand for loans was very weak across residential mortgages, commercial real estate, and business loans. We saw bank lending conditions for consumers tighten pretty aggressively.

The Fed thinks that this is going to take away from the need to raise rates further, that it's going to impact demand, therefore help to bring down inflation and impact the labor market as we look ahead. Calibrating that at the moment I think is really, really difficult. I would agree with them that that's going to be a big impact on the economy.

- I mean, this comes after we're continuing to see this hit on deposits for some of the regional banks, as Julie was mentioning. So with that in mind, we've heard the messaging over the course of the earnings season that the banking system is still fine. It's still strong. But at this point in time, investors trying to get ahead of something else. Is there something else, another shoe to drop here?

MATTHEW LUZZETTI: Yeah, I think what we see in the aggregate data, we get from the Federal Reserve usage of their lending facilities. It's been stable and actually declining over the past several weeks. I think that's been a positive development. We'll get another data point on that this afternoon.

When you look at the Fed's H.8 data, it looks at deposits and bank balance sheets. Again, that's been pretty stable over the past several weeks. So when Chair Powell says that the system is stable and broadly improved since early March, I would agree with that. Certainly there are fundamental stories going on, which is that market rates are well above a lot of deposit rates. And so it makes sense that depositors are looking for higher investments elsewhere.

- We talked earlier in the show about how low the approval rating of the Federal Reserve chair has fallen right now, and that it's perhaps not surprising because people are not feeling great about the economy. The Fed is purposefully slowing the economy in order to bring inflation down. But I do wonder, the discussion not so long ago was all about the Fed making a mistake and needing to pivot when it didn't act quickly enough to address inflation. What's the biggest risk of a mistake now on the part of the Fed?

MATTHEW LUZZETTI: Yeah, I think to your point, we always talk about the Fed taking away the punchbowl before the party gets started. So that's usually not a high approval rating for the person that has to do that.

The risk today, I think, we don't expect the Fed to raise rates again. We think that their last rate hike was in May. But the risks at the moment are we've seen inflation data, which remains pretty sturdy at elevated levels. We've seen a labor market with the jobs report last week that was really, really robust.

And the risk, there is a risk here that the Fed is stepping back, thinking that credit conditions are going to tighten and that they don't have to do any more, but that we're forced to replay this kind of start/stop hiking cycle that we had during the 1970s. Ultimately, that proved to be a far more painful experience. I think that's the new risk that the markets have to deal with.

- So that's really interesting that you say that because there are certainly some critics out there who are saying that the risks are balanced the other way, that the Fed risks being too aggressive. It sounds like you are taking the opposite side of this, that inflation could actually prove to be even more persistent than the Fed is planning for.

MATTHEW LUZZETTI: Yeah, I think what we've seen over the past year was a Fed that was willing to overtighten because inflation risks were the key objective from their perspective. I think the credit conditions what we're seeing in the banking sector kind of just injects a new uncertainty, injects a new risk for the Fed. We know that they're stepping back from rate hikes at the moment.

If we did not see what was happening in the banking sector, it is likely they would have raised rates by 50 basis points at the March FOMC meeting. And so they have already not done as much as you would have expected if not for what was happening in the banking sector. So really, it's maybe not the key risk, but it's a new risk that markets have to deal with, this idea that inflation is still too high. The labor market is still resilient for the time being. And it's possible that after taking a break, the Fed has to rehike rates later this year.

- And so what does that, in turn, do in the labor market as well? Is there a byproduct that becomes-- that comes as a result of that? Because the employment situation, to your point, has remained strong to this juncture.

MATTHEW LUZZETTI: Yeah, I want to bring in this morning's data as well. We did see jobless claims, particularly initial jobless claims, spiked higher. And up until the latest week, it just looked like they were moving back towards levels that we saw in 2019. This is the first time where we've seen them very clearly rise above the 2019 levels.

Claims, I think, are the best contemporaneous indicator for recessions. I'm not saying that they're suggesting recession today, but if they were to continue to rise, it is a real concern, I think, that the labor market begins to weaken. Outside of that, the rest of the data, certainly last Friday's jobs report was robust across the board. So mixed signals from the labor market at the moment.

- While we have here, I got to ask about the debt ceiling, unfortunately. If it happens, GDP hit. If it lasts a month, GDP hit. If it lasts two months, GDP hit. Have you guys been gaming out all of those scenarios?

MATTHEW LUZZETTI: Yeah, look, I think it's hard to quantify exactly the impact. I think we know probably two things at least. I think getting to a resolution is likely going to require that markets react, that they force the two sides together, that you have some downtrade in the S&P 500, some widening in your credit spreads. That tightens financial conditions and ultimately impacts the economy.

I think the second thing that we're likely to see is that we do get some spending cuts legislated, probably not nearly as large as what is in the Republican plan. But meaningful spending cuts are likely necessary as part of a deal. Both of those things are negative for growth at a time where we are already worried about recession risk. We're talking about banks tightening credit standards. It's this event risk plus the underlying backdrop why we've stuck with our view that Q4 is the start of the recession.

- Well, the markets so far are definitely are not forcing their hand. So we might, June 1, we'll see how close we get to the deadline before that happens. Thanks, Matt. Great to see you. Matthew Luzzetti is Deutsche Bank Securities chief US economist. Great to get some time with you always.