US Weekly Economic Commentary: Financial turbulence reflects and creates uncertainty

While financial turmoil surrounding the sudden demise of Silicon Valley and Signature Banks dominated headlines last week, other data suggested the economy continued to advance in the first quarter, when it seems increasingly certain the economy did not enter a recession.

Core retail sales — which exclude sales at gasoline stations, motor vehicle dealers and building material and supply dealers — were revised up for December and January and were flat in February when we anticipated a decline, in part as a payback following January's surge.

Housing starts — and, more importantly, housing permits, which are measured more accurately and are less likely to have been influenced by recent unseasonal weather patterns — jumped in February.

Manufacturing industrial production was revised up for January and eked out a small, second consecutive monthly gain in February. Within production for February, vehicle assemblies were stronger than we anticipated.

In response to the week's data, we raised our tracking estimate of first-quarter growth by 0.9 percentage point to +0.6%, up all the way from -1.9% in late January. Furthermore, we see some upside risk to our estimate. For example, the Atlanta Fed's GDPnow, showing stronger consumer spending, net exports, and inventory investment than we do, anticipates strong above-trend Q1 growth of 3.2%.

Swift regulatory action

Although inflation has come down, it remains stubbornly elevated, highlighting the difficulty of squeezing it down further towards the Fed's 2% objective.

While the report that producer prices softened in February was helpful, core consumer prices bucked the declining inflation trend and rose 0.5% for the month, following increases of 0.4% in December and January. Also in February, with the dollar having lost value since October, the price of non-fuel imports advanced for the third consecutive month following seven monthly declines.

Nor is there any sign of relief from inflationary pressure emanating from tight labor markets: initial claims for unemployment insurance declined in the most recent weekly data, and continuing claims are bouncing along at low levels.

By themselves, these developments suggest upward revisions to our forecast of GDP growth that would have re-enforced what had been investors' growing expectation that at this week's meeting the Fed might announce a 50 basis point hike in its policy rate. The collapse of SVB and Signature Bank has changed that calculus, at least for now.

Regulators did act quickly to seize control of the failed banks, and the Fed moved aggressively to calm investors' fears of contagion spreading to other banks by announcing the creation of a new lending facility from which financial institutions can borrow for up to one year, on favorable terms, and by pledging collateral at par rather than market values. This allows banks to raise cash while avoiding selling assets — the prices of which have fallen with rising interest rates — at a loss.

Later in the week, a consortium of big banks joined forces to infuse struggling First Republic Bank with $30 billion in deposits. These initiatives helped stabilize markets. Nevertheless, on Friday the S&P 500 index ended up 1.4% for the week to close at 3,917, and the 10-year Treasury note yield declined 31 basis points from the Friday before, reflecting a strong flight from risk to quality.

Potential new headwind

Futures markets still expect the Fed to hike its policy rate by a just one quarter point next week, and that is our (unchanged) call as well. Our view is partly conditioned by the incoming data on growth and inflation.

We also believe the Fed will want to demonstrate that it can simultaneously use its macro-prudential tools to address problems in the banking system while showing its ongoing commitment to reining in inflation using the traditional tools of monetary policy.

How far off course has our forecast for this year been blown by the turmoil emanating from the banking sector? It is, obviously, a potential new headwind, and could become a significant drag if not contained. Households' holdings of equities have already taken a hit, and that suggests adverse wealth effects on consumer spending. Spreads of private yields to Treasury yields have risen sharply, and that will discourage risky investments.

There likely also will be a tightening of lending standards and curtailment of bank credit expansion that will be exacerbated in regional markets to the extent deposits flow towards larger money center banks. The resulting curtailment of credit would slow economic growth.

We note that some forecasters already have marked down their projections of GDP growth this year, and/or scaled back their calls for further monetary tightening. While acknowledging the reasonableness of these "leans," we think it too early to move aggressively in these directions. We will need to judge the remaining degree of financial fragility and whether the drag on growth from the recent financial turmoil may simply substitute for one or more Fed rate hikes.

In our April forecast round, which starts in two weeks, we expect to revise up our projection for first-quarter growth. At that time, we'll assess whether developments in financial markets since our last forecast imply a sufficient tightening in financial conditions to support a downward revision of the forecast after the first quarter.

This week's economic releases:

• Existing home sales (March 21): We estimate 4,198 thousand units for February, up from 4,000 thousand units in January. A jump in existing home sales in February, which are recorded at the time of closing, would reflect a previously reported jump in pending home sales in January, which are recorded at the time of contract.
• New home sales (March 23): We estimate 647 thousand units for February, down from 670 thousand units in January. A decline in new home sales in February would only partially reverse solid gains in prior months.
• Durable goods orders (March 24): In real terms, manufacturers' orders for durable goods have been on a broadly flat trend since late 2020.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.