Bank failures complicate the picture for the US economy

I was really hoping to write a column this month in which I did not feel compelled to discuss the subjects of inflation, interest rates and Fed policy. Those topics have dominated the news for many months, but as of a couple of weeks ago, it seemed the situation was starting to stabilize.

Recent data indicated the pace of inflation was moderating and the labor market was showing signs of cooling. Jerome Powell had confidently and credibly testified to Congress that the Fed was resolute in its efforts to do whatever it took to get inflation back to acceptable levels. So I was starting to look forward to columns focused on topics and end markets specific to the plastics industry.

Then there was a run on a large U.S. bank (Silicon Valley Bank), and shortly thereafter, regulators took control of another large bank (Signature Bank). An actual run on a U.S. bank — that was something my grandfather told me about recalling his experiences from the Great Depression, but I never worried about one. We live in a world with the FDIC and Dodd-Frank and instantaneous market data and enlightened regulators, etc. Besides that, we are not in an economic recession, and there are no signs of any kind of market bubble anywhere.

Nevertheless, we had a run on a large, well-established bank. By the way, just a month before SVB collapsed, Jim Cramer rated its stock very favorably to all his viewers. And just two weeks before SVB's demise, KPMG had submitted an audit report that gave SVB's books a clean bill of health.

As of this moment, there does not appear to be any contagion effect. But it is still too early to say we are out of danger, and the longer-term implications pertaining to the path forward for policy makers and regulators are far from certain.

This was a wake-up call for any business owner or senior executive whose job requires them to manage risk. And that is true for all companies in the plastics industry. Let's be brutally honest with ourselves: How many of us even had "a run on our preferred banking institution" on our list of potential risks for our respective businesses this year? For me, this particular risk was on the list of "unknown unknowns" — a black swan, if you will.

So now that I am armed with this new information, I want to review my list of known risks and make any necessary revisions.

As I said, it was clear to me that the Fed's recent policy of rapidly tightening financial conditions was starting to have the desired effect: The rate of inflation was moderating. The only question up until the SVB collapse was how much more tightening would be required. We know there is a lag between when the Fed starts a tightening cycle and when the effects of higher interest rates start to show up in the data. But there is great uncertainty about how long the lag will be; therefore, there is great uncertainty about how much tightening is required to slow the economy just enough, but not too much.

As the Fed raised interest rates, which, by the way, were raised higher and faster than at any other time in history, I am sure their only focus was on inflation. But as we now know, they tightened so quickly that some financial institutions did not have time to adjust. Many individuals and businesses with portfolios of fixed-income securities have taken a hit. And many depositors have discovered there are much higher rates of a safe return outside of a bank account.

So if you own a bank, and the value of your reserves of U.S. treasuries has declined while at the same time your level of deposits has also declined, then you are now feeling stress. Did the Fed, in their singular desire to quell inflation, embark on a pace of interest rate hikes that were too fast to allow for banks and other financial institutions to adjust? Are there other vulnerabilities within this sector that will soon be exposed?

Furthermore, if the Fed decides to stop raising rates, or even take a pause, due to worries about the financial sector, can we be sure they have done enough to get the rate of inflation down to an appropriate level? And is there a chance, that in all of this uncertainty, the financial markets will lose faith in the Fed's policy reactions and then start to panic?

The Federal Open Market Committee, which sets the Fed Funds Rate, is scheduled to meet March 22. Members will no doubt find themselves in a precarious position. On the one hand, if they proceed with their well-documented plan of raising interest rates a bit higher in an effort to ensure they are driving down inflation, then will they exacerbate the newly emerging problems for the banks?

On the other hand, if the Fed does not raise interest rates, as it previously indicated it would, how will the markets respond? Will the markets presume the inflation target will not be achieved and that the Fed's credibility is dubious? Or is the prudent course of action to take a deep breath, slow things down a bit, take a closer look at the trends and the data and allow a little more time to give everybody a chance to adjust and find their footing?

One clue about how the market might respond can be found in the yield curve. I have included a chart of the most recent data, which shows a yield curve that is extremely inverted. In a healthy economy, the line should steadily rise as you move to the right. There is a lot of debate about what is currently causing this inversion and what it means for the future, but one bad thing about it is that banks have a hard time making a profit when interest rates look like this.

Now just for the record, I believe it is still possible for the Fed in particular, and the U.S. economy in general, to navigate all these issues successfully and come out on the other side stronger than ever. In other words, there is upside risk in almost any situation, and this time is no different. I believe inflation will be brought under control eventually, and the U.S. economy can expand in the future at a stronger pace than it is currently growing.

However, I am not at all sure that is what is going to happen in 2023. At the present time, I am not forecasting a soft landing or a hard landing this year. But I am not ruling anything out. The situation is too tenuous for me to engage in any type of meaningful forecasting activity. If the Fed, with its vast amounts of resources, experience and brainpower, finds itself in a quandary, then it would be hubris for me to state I can do any better. Sometimes, we just don't know.

My only advice is that you must assiduously assess your company's risks and then vigorously work to put your business in a position of strength. For a good case study on how to accomplish these obvious-sounding objectives, study closely what just happened to SVB — and the deceptive affirmation its management and its investors received from their auditors — and then do the opposite.