Federal Reserve Bank Member Suggests a Companion Tool to Battle Inflation.

To accelerate the finality of rate hikes, Cleveland Federal Reserve Bank President Loretta Mester offers up a complementary approach, one that should directly impact business and consumers.

Today, Loretta Mester said that interest rates need to rise above 5% given stubborn inflation, but how much above 5% will depend on economic and financial developments.

“I do think that given how stubborn inflation is and given the still strong labor market, I do think that rates are going to have to move up to above that 5% level,”

“What we really need to do is we need to make sure that we get that inflation rate on that sustainable downward path. That’s my focus,” said Mester. “The tightening of credit conditions, either from the Fed or perhaps from banks, tightening their lending standards, that’s more of a mechanism for getting that done.”

The tightening of lending standards, ie, more denials of loans than acceptances, higher collateral requirements, reduced borrowing commitments or an all-of-the-above approach, serves to dampen economic growth while simultaneously reducing financial leverage. To a great extent, the deposit runs experienced by many regional banks has already served to reduce “loan-shopping” by borrowers as only a very select number of money center banks presently maintain the ability to entirely fund any respectable loan. Furthermore, syndication participation has likely shrunk in tandem as many banks will have placed an informal moratorium on borrowings.

Coordinated tightening of loan standards by the money center banks, coupled with the end of regional bank participation in loan bids, could be precisely what is needed to slow consumer spending to the equilibrium level required to cap inflation.

“will stresses in the banking industry, those stresses in March lead banks to move faster, to tighten their credit standards, and if so, credit will become less available,” she said. “That has the same kind of impact on the economy as tightening a monetary policy.”

This, of course, would be bad for bank revenues and likely profits; banks require new loans at higher rates to mitigate the t-bond mismatches currently on the books. What at least one Federal Bank President is articulating, represents a moderate “run-off” mode on bank balance sheets. This will not be well received by bank investors and could conceivably lead to more regional zombie banks as a result.

PPI and CPI inflation, since 2020, are gradually narrowing their differential between M2 money supply, which occurred in the aftermath of the Covid-19 pandemic.

Through March 2023, PPI had increased by 26.8% from the end of 2019 (196.40 to 249.12). CPI has increased over the same timeframe by 18% (255.66 to 301.84) M2, the true driver of inflationary pressure, has advanced by 37.4% since the end of 2019 (15,320 to 21,062). Producer prices are closer to capturing the increase in global liquidity. Consumer prices, regretfully still have some room to run before relative equilibrium may be reached.

Collusion in private business is strictly verboten. However, when it comes to central and money center banks, moral suasion isn’t considered a breach of protocol.

If one takes the telegraphed wording of President Mester at her word, which I do, and provided that she is relaying the intent of the US central bank as a whole, which she is, the coming several fiscal quarters will demonstrate an incremental tightening of loan standards. It could reach the point that only those not in need of a loan may actually qualify to obtain a loan.

This is the Faustian bargain, the concession that the US Federal Reserve quietly received for bailing out the entire US banking industry in Q1; (we, the US central bank, will do what needs to be done to maintain the pretense of banking industry solvency, but in return, you will tighten the loan spigot).

The prospect of across-the-board credit limiting actions by private banks, coupled with further fed hikes and continued steady, albeit, more moderate, withdrawal of M2 money supply, will get us much closer to the new normal for pricing we must all accept, based on the current M2 money supply.

But overlaying tighter lending standards, in tandem with a 5% fed funds rate, in the view of President Mester, takes the outlook for US GDP in 2023 down to a range of +1% to 0%, or lower.

For those who do not require external capital for personal or business growth initiatives, tightening of credit standards could represent the buyers’ market of choice, one featuring limited bidding competition and affording one “time” to pick and choose, to more capably sort through opportunity.

As to those businesses and consumers presently too heavily leveraged, a 1% GDP growth rate might not officially be classified as a recession, but it will sure feel like one.

Fed’s Mester says rates need to rise above 5%, reserves decision for next policy meeting