Goldman Sachs increased the likelihood of a recession from 25% to 35% in light of the SVB-related turbulence (although their estimate is still below consensus). This got me wondering what the net effect of the turmoil and the Fed’s response (less tightening) was on economic activity.
First, the trajectory of fed funds – as perceived by the market – on Sunday compared to a few weeks ago.
Figure 1: Effective Fed Funds (black), Implied Fed Funds as of March 19 at 4:30 a.m. CT (red square), March 14 at 1:30 a.m. CT (pink square), March 8 (sky blue inverted triangle), and February 15 (green triangle) . Source: Fed via FRED, CME Fedwatch and author’s calculations.
At the end of the year, implied fed funds are about 180 basis points lower than they were nearly two weeks ago. Bauer and Swanson (ARE 2023) estimate that a shock of 100 basis points leads to a decrease of 0.24 to 0.60 percentage point in the growth rate. Of course, a 180 basis point lower rate is not really a “shock” as considered in the VAR literature (the reduction is based on an inferred reaction function that takes into account weaker growth prospects), but let’s take that figure as a ballpark figure. This implies a less pronounced crunch that adds around 0.4 to 1 percentage point to growth. Let’s say the half of 180 basis points is a “shock” in the sense that it is driven by concerns about the banking system. This then takes a positive impact of between 0.2 and 0.5…
On the other hand, the shock suffered by the banking system should reduce bank credit, and therefore growth. Luzetti et al. at Deutsche Bank (“(Credit) crunching the numbers”, March 20, 2023) estimate that a 10 point increase in the Senior Loan Officer Survey (SLoOS) in loan terms (which was typical in recessions in the 1990s and early 2000s) would lead to a reduction in growth of 0.4 percentage point over a horizon of 4 quarters.
Remarks: A 10-point increase in SLoOS is approximately equivalent to 1 standard deviation shock from FCI. Source: Lucetti, et al. (2023).
I wouldn’t consider this to be anything more than a back-of-the-envelope calculation, but it does remind us that there are offsetting effects of recent developments.