Pulling the Liquidity Thread

• US banks are now in full “precautionary mode”, but the Fed may be reconciled with a credit crunch, as long as it’s not too disruptive
• The ECB cannot rely on the same wealth of near-real time indicators as the Fed to gauge the impact of the banking stress on the real economy – the burden of proof to alter the policy stance is however high in our view

The Fed can rely on a wealth of near-real time indicators to gauge the ramifications of the banking stress for the real economy, with weekly data on deposits, banks’ leveraging and lending. It is now clear that the entirety of the US banking system – and not just the smaller institutions – has put itself in “precautionary mode”, hoarding cash, often obtained by a massive recourse on the Fed. Generous liquidity cannot deal with solvency issues, but it can provide breathing space to banks. More creativity could be seen in this field in the coming weeks. Beyond emergency support, the Fed may also have to re-think its framework as banks have to deal with the attractiveness of money market funds, to which their participation to parts of the Fed’s own liquidity management system contributes.

Last week’s decision by the Fed to hike by 25 basis points and maintain a tightening bias for the path ahead – albeit a weak one – is testament to the strength of the “separation principle” we discussed last week. True, the tightening in monetary conditions, explicitly acknowledged by the FOMC, makes it less likely the Fed will have to go much further – we now expect only one additional hike in May – but like the ECB, the Fed “would rather” continue to hike.  We think we are faced with a central bank which may conclude that a credit crunch is a painful, risky but ultimately necessary and probably unavoidable step on the way to disinflation.

The ECB cannot rely on the same wealth of near-real time indicators. We will have to wait until only 2 days before the next Governing Council in May to get qualitative information on the banks’ outlook for credit origination (in the next Bank Lending Survey) and actual volumes of credit originated in March. Our impression is that the burden of proof to alter the tightening path is high. The ECB is probably taking some comfort in the fact that Spain, the “usual suspect” in terms of quick adverse reaction to higher rates in the Euro area, is faring much better than the “canaries in the coalmine” in the North of Europe, notably Sweden, we highlighted a few weeks ago.