Hello, and welcome to the Download. I'm your host, Dave Richardson, and it is time for Canada's hardest working economists to join us. And it's been a hard-working month for you this month, Eric. This has been an eventful one.

Yeah. Only two weeks of vacation for me. My greatest regret, Dave, is that I did go on holiday, and it was lovely, notwithstanding five missed flights, but it was good. We'll forget that transportation adventures that were part of it. But I decided I would work the Monday before flying out in the evening and I thought, I’ll catch up on some reading and so on. That was the Monday that the banks were failing left and right. That proved to be a rather busier day than I'd budgeted for. I got tasked with writing the emergency article for the firm and was doing that until 4, and the taxi was at 4:15. And then I had to start editing other things on the ride to the airport. And so I could have done with a bit of a smoother journey. But in any event, it's been a busy month, even if I wasn't here for the whole thing.

This is why you're Canada's hardest working economist. Other economists just would have hopped on the flight and forgot everything. You had to get in there and provide that support and that insight into what was going on. I also ended up working most of my vacation because of that. Let's talk about that, because the last time we got together, we were on the February jobs report in early March, and we'd just gone through a series of data coming through February and early March that started to suggest that maybe inflation just wasn't coming down. The job market just continued to be strong. And you were even questioning yourself in terms of: I've had this forecast, I've been bang on until now, and then all of a sudden, things just aren't slowing down as much as we expected. But boom, here come the cracks or the break of something that the Fed wants. And things are where you always thought we'd be about here?

Yeah, I think so. I didn't have particular bank names in mind or anything quite like that. When we talk about interest rates going up— and that's been the theme as central banks respond to inflation—, there are traditional economic channels, and those have proven a little slow in coming. Higher borrowing costs are supposed to slow down spending plans and they're supposed to increase discount rates, which discourage risk taking and investing and all those sorts of things. And so those will still happen, and I think we see bits of that happening. But it is taking a sweet time, if I'm being fair. And maybe part of it is because inflation-adjusted rates are still pretty low when you do it that way. But the other channel, and it happens most times, is that you get some financial distress or contagion from higher interest rates, and as much as regional US banks and Credit Suisse are in the headlines now— let's circle back to those in a moment— and we did get British pension funds last September— it's probably a bit of a stretch to claim that crypto problems were also in there—, but funny things happen when variables start moving and so maybe you could stretch yourself in that direction. But quite clearly, what's happened recently is related to higher interest rates. I won't go through the boring details— you've done that with Stu Kedwell and probably with others at this juncture— but we've seen some regional banks that have had distress. They were special in the sense that they were very skewed towards a particular sector, a tech sector that was struggling, and money was already coming out and there were bigger clients who then weren't protected fully by deposit insurance. And Silicon Valley Bank in particular had a lot of bonds in its portfolio when it hadn't hedged the bonds, and they were long-dated bonds, and it bought a lot of those bonds in 2020 and 2021, just because it was growing so fast. That was when they had assets to purchase, but it was at the peak of the bond market. In theory, losses on bonds in a bank don't matter that much so long as you get to hold the bond to maturity, which was surely the plan, because you get restored to par. But then when money starts flowing out, you need to crystallize those losses and they end up insolvent. So, I mean, that's the long gory story there. And we've seen a few other banks in a similar situation, and the government has fairly credibly stepped in with a liquidity program that in theory means that anybody else with a similar paper loss that could render them illiquid or insolvent, they should be liquid and at least solvent in a pragmatic sense over the next year, in any event. That's all fine and good, but I think you do circle back to the idea that we're seeing some financial problems arise. That makes sense. I presume we will continue to see some measure of distress in different places and I'm not quite clever enough to say whether it's a few of the other regional banks that are struggling or whether it's emerging market borrowers, a quarter of whom can't easily access the market. There's lots of places that are levered and borrowing and experience some stress when rates go higher but it's fair to say that this is also a relevant channel for dampening the economy. And so you think about how people are behaving after this banking stress versus before, and risk taking surely is down and credit standards are surely tightening. Consequences in particular, maybe US commercial real estate seems to be quite intertwined with the regional banking sector in particular, and financial conditions have ultimately tightened. Spreads are wider and things like this. It's almost as though the Fed hike rates a few times, maybe just in terms of the actual borrowing costs that people might now face. And so all of that does dampen the economy. So what have we done yet? We've had moments of doubt; there always are when you're making these big bold calls. But it's always made sense that there should be a recession, just given the magnitude of the tightening and the inverted yield curves and any number of a laundry list of arguments as to why you'd normally get a recession coming out of this. But now we're getting this other box that's being ticked as well. And so I guess, for what it's worth— and this is very much a hazy inexact science and no one's allowed to ask for the underlying model here—, but we were saying the risk of recession was about 70% over the next year; we just bumped it to 80%. I mean, this is still such a weird post-pandemic environment that I wouldn't want to talk in certainties or 100% likelihoods, but it's more likely than it was before. And we're certainly very content to maintain a below consensus growth forecast because we think there is some damage that comes from that. So I guess that's the long story, not so short.

The view on the percentage forecast on the recession goes up. Any change in terms of your view of the depth or length of that recession? That's hard to do anyways at the best of times. But has anything that's happened make you think that there's the potential that it's a little bit more severe?

At a minimum, I think that scenario exists. The downside risks were significant before, and we had a long list six months ago, and many of them are still there and they're still the debt ceiling and there's still Japan. There's another spot where rising rates could be tricky in Japan where you've got the zombies of public debt and things like that. We revisit formally the forecasts over the next couple of weeks, so I don't have a brand spanking new number for you to share. But yeah, it would make sense that the risk is a bit more. In recent quarters, we’ve been saying mild to middling recession, a number that really straddles the fence between those two outcomes. Maybe back to the middling story we had going a little while ago. So I think that's it. I still don't think there are too many parallels to the global financial crisis. I know it's tempting to argue there are, because you tally up all the paper bond market losses and it's 600 to 700 billion. That is a pretty big number. And you start comparing it to the capital of banks and it could be some challenges there. But keep in mind, nobody has to crystallize those losses now with this liquidity program in place. And we know what bonds do over their full term, which is they do return to their par value. And so I don't see it as being quite the same. We don't have a collapsing housing market, we don't have problematic disintermediation, we don't have opaqueness around these little-understood asset-backed products. That was previously the case. But most importantly— and I think this number is right—, the average bank is two to three times better capitalized than it was in 2009. That gives you a pretty good amount of rope before you run into trouble. So this is banking sector and it is financial stress. And we saw it with Credit Suisse. To my knowledge, it was not bond-market losses. It was more an effectively non-viable bank ever since the global financial that doesn’t make money, and it was already saying it had no plans to make money over the next three years or so, I believe, and with the stress elsewhere, people said they probably had enough with this. UBS took over. The poor UBS CEO somehow lost his job in the middle. I'm a bit perplexed about that one. But anyhow, UBS took over. And that new entity seems to be amply capitalized and have ample liquidity. People made a run at Deutsche Bank. But again, it seems like it's a viable bank. And so in the end, problems do surface when rates are rising and concern is high. But at this juncture at least, I don't see why it has to be another global financial crisis. And to answer your question, most indirectly, that's why I don't think it has to be a profoundly deep recession.

Please join us in two weeks for Eric's next appearance when he has all of his new forecasting out as you're crunching those numbers over the two weeks. So that's a little tease for a future episode. One more thing around the banking sector and the response from the central bank: does that worry you longer term, the way government agencies have come in and backed all these deposits and put up that trading counter to take those bonds that are mistimed relative to the deposits that are on the bank's books? As an economist, I wanted to ask you this. Moral hazard? Does this worry you longer term that this could create bigger problems in the system somewhere down the road?

It does worry me a little bit. It's not quite a bailout, but a bailout kind of thing and so in theory it does encourage a bit more risk taking down the line. Now, do let the record know, and people grumbled about this a lot during the global financial crisis— rightly so; there was a lot of money directed towards bad behaving banks—, but keep in mind, not too many bankers benefited enormously from that event. For the bad behaving banks, the equity was more or less wiped out and the CEOs were out on the street and that sort of thing. And so I wouldn't say the conclusion was, hey, let's do this again and get a bailout again. It was ultimately a very painful experience for all parties. So I wouldn't want to be quite so glib as to say, hey, it's party time for banks now that they know that if they make a mistake, their depositors are maybe okay. But equally, yeah, I mean, when you do this sort of thing, it does encourage a bit more risk taking. And I think the thing that maybe bothered people the most was that these two banks that failed were given 100% deposit insurance on the whole sum. And that wasn't the promise. There's a whole insurance system in place and it's even a bit unfair to the extent that other banks are now going to be levied a surcharge effectively to compensate for that. And maybe the reality is if someone else failed, a year from now, that you'd see them also enjoy the same benefits. So maybe it's not quite so unique or special, but it's not great when you have an insurance program and then you change the rules every time the insurance program gets tapped. It was a little bit like the CO-CO bond story in Switzerland and maybe normally, under normal circumstances, we wouldn't have wiped out the CO-CO bondholders first. Well, there's never a normal circumstance when a bank is failing and CO-CO bonds are failing. I wasn't sure that had a whole lot of meaning to me. I will say I feel a lot better that other countries don't have that same funny clause in their CO-CO bonds. And so it seems like they are further up the capital structure and people can feel fairly confident in those. And it is a nice way to pick up extra return in exchange for a spot on the bond hierarchy anyhow. But I don't know, normal never really applies. The whole Mike Tyson’s «everyone's got a plan till they get punched in the face out the window». So yeah, I mean, I think it's inevitable that there was some of this and I think the government broadly chose the right solutions. But equally, banks that misbehaved are now able to tap this liquidity. Do note, by the way, the liquidity is far from free though. They're paying about 4.7% for this borrowing cost. And so if you were a non-viable bank, if you just did not have a business model that worked, that would be a big problem and you would run into trouble anyhow. And so I take some solace that this really is reasonably expensive. The government is turning a profit, is the right term, but nevertheless the government is charging a proper fee for this service. And keep in mind, in a worst-case scenario where banks were to fail despite using that service, and it's hard to fathom that, but despite that, well, the central bank does not experience short term financial stresses. And so it would then just hold those bonds to maturity and it would feel pretty assured of getting its full value back. So yeah, there's the risk of a bit too much risk taking. But equally, maybe the way to put it is I'd rather they do those things than cut the policy rate in response to this because central banks have this very tricky situation where there's still too much inflation. And so that's kind of in the priority suddenly of this new thought, which is financial stress, and the normal instinct is to cut rates. But there's this tension between the two things. I personally think they need to stay focused on inflation. Inflation, by the way, is looking a little better recently, with PCE deflator coming down a bit in the latest numbers in any event. And so I'd like them to keep focusing on inflation and deal with the banking stress via these other tools. So ultimately, I'm resigned to this being the best of a bad set of options and I guess I will say as much as I think they need to stay focused on inflation, I do get that central banks probably don't need to tighten quite as much as before just because the market did it for them. Financial conditions just tighten, spreads are wider, that is worth a bit of tightening. I'm not quite convinced we're getting cuts in the near term, but nevertheless they do need to hike a little less than before.

Yeah, the policy response here, the response that the central bank had and governments is, it stops that line up in front of the bank window, pounding the door like a «It's a Wonderful Life» reference. A lot of people have seen that movie, the run on the bank, or in today's world, pull up your smartphone and push the withdrawal button to take your deposits out. It just says to everyone, okay, we don't have to do that because we're good; it calms things down and then we move forward. Now, let's just finish off because you did already referenced it, the PCE deflator number out this morning and a little bit better than expected, which is a reversal of where we were when we referenced at the front of the podcast the numbers we were getting in February for January. And this is the one the Fed really likes, right, in terms of measuring inflation?

That's right, because the backstory of course inflation has been much too high. Inflation started to cooperate in North American context around the middle of last year. So we had some nice months there where we're really pounding our way lower in inflation and we entered 2023 with good momentum. And then January data, sort of iffy, gas went up a bit and some other things didn't come down that much. And we had February CPI already. Again, it was okay, the annual numbers are falling, but just the monthly trend, you sort of do the math and say we're still stuck around a 5% annualized rate here, which isn't quite what we want. It's not 10% anymore, but it's not 2% either. But you're right; we just got the PCE deflator for February as well— this is the Fed's favorite measure, so we certainly should pay attention to it— and it did for once cooperate a little bit. So we got a slightly better than expected outcome. And so overall, the overall deflator fell from 5.3 to 5.0%. So 4.9% is still a high rate of inflation, but I'll take some symbolic celebration when we get below that. So we're on the cusp of that. And actually the core PCE deflator, again, annual, did just do that. So it's now down to 4.6% year over year, and that was again a little bit less than the market had assumed. And to be honest, with the annual numbers, it's almost baked into the cake that you get an improvement every month, just because we have such incredibly large monthly gains a year ago; they're falling out. The question really is what do the monthly numbers look like? And not bad. So we got 0.3% monthly gains and anyone who's good with math will know that does annualize up to 3.5 or 4% inflation. So this is not to say that we are totally back to a normal trend here, but for context, recent months of the CPI were going 0.4 and 0.5%. And so I'm feeling pretty good about clicking along at 0.3%. Again, each month can be different. There's no guarantees here, but I will say the very tentative evidence I've seen for March is looking promising for inflation. I've seen a few real time measures that are really falling in March. I've seen a couple of references. I guess we know that oil prices have fallen in March and those sorts of things. So I think the March data is going to look pretty good. And so, I'm feeling happy that February maybe wasn't all that bad.

So with that core PCE deflator number we were just talking before we started taping that, your Fed Funds rate is now above that. One of the things that you need to do when you're in a rate hiking cycle is get that Fed Funds rate up above the real rates of interest. You're starting to get pretty confident that we're almost done with that hiking? If things continue to behave this way, we're really getting close to where they're done?

I think so. To begin with, that's certainly what markets think. Market is even debating whether there is another Fed hike and thinking that the bank of Canada is probably done; there's a little more lifting for the ECB and the bank of Japan, and the bank of England, but nevertheless, it seems like we're pretty close. And it makes sense. That policy rate is now just about double what a neutral rate would be. We are pretty deep into restrictive territory here. So that's helpful. As you say, one of the twists so far, and maybe one of the reasons there hasn't been that much economic damage yet is that the real rate— at least if you subtract the policy rate minus CPI or PCE deflator— it was still a negative number. So inflation was just so high that it didn't feel all that restrictive. And so I guess some symbol is just manifested in the sense that here we are now, a core PCE deflator of 4.6%, a policy rate that's a tenth higher or something. And so I guess we can say we're in positive real rates, as you indirectly alluded to. Of course, there's other ways of defining real rates. Other measures would already have been positive for a little bit, but nevertheless, that tells us we're making some progress. But I guess the bigger signal is just that inflation is coming down, maybe not perfectly and somewhat fitfully and we may not get all the way to 2% this year, but nevertheless we're getting some cooperation there and that is practically the sole focus for central banks right now. The leads and lags are such that it's an inexact science, it's a bit of a guessing game. I think that it comes down to the situation in which can you afford to stop if you're not confident that you're on the right trajectory. So it'd be really nice to get a bit of a pause here because at least in the US, we don't get the next rate decision till May. And so we are going to get another month worth of inflation data. I think it might look pretty good. We're going to get a better sense for what this banking stress has done and maybe there's going to be some greater confidence that we're genuinely on the right path.

Excellent. Well, Eric, again, thanks as always for joining us and thanks for all that great work. I'm sure some of the listeners were privy to the work that you did as that turmoil popped up in the banking sector while you were on vacation. You're always a great read, a great follow. And we always appreciate you joining. And we're going to look forward to some of the work that you're doing over the next couple of weeks when we check back in with you on the jobs report and the next sets of data that come out. So, Eric, thanks again.

Okay. Thanks, Dave. Thanks, everyone. Bye.