The Federal Reserve is getting some unwanted help in its drive to slow the U.S. economy and defeat the worst bout of inflation in four decades: A cutback in bank lending.

The upheaval in the financial system thats followed the collapse of two major U.S. banks is raising the likelihood that lending standards will become sharply more restrictive. Fewer loans would mean less spending by consumers and businesses. That, in turn, would make it harder for companies to raise prices, thereby reducing inflationary pressures.

At the same time, some economists worry that the slowdown might prove so severe as to send the economy sliding into a painful recession.

On Wednesday, the Fed raised its benchmark interest rate for the ninth time in just over a year. The central banks policymakers are struggling with a persistently high inflation rate that has bedeviled American households and heightened the uncertainties overhanging the economy. At roughly 6%, U.S. inflation remains well below last years peak yet is still far above the Feds 2% annual target.

But the Fed also signaled that it might be nearing the end of its rate hikes. In part, that is because a decline in bank lending could help the central bank achieve its overarching goal of slowing the economy and taming inflation.

Speaking at a news conference Wednesday after the Feds announcement, Chair Jerome Powell suggested that stricter lending standards, resulting in a pullback in loans, could have the same slowing effect on inflation that a Fed hike can.

It doesnt all have to come from rate hikes, Powell said. It can come from tighter credit conditions.

Similarly, after the European Central Bank raised its own benchmark rate by a substantial half percentage point last week, its president, Christine Lagarde, said the ECB was not locking itself into a preset plan for rate hikes and that future rate decisions would be made on a meeting-to-meeting basis.

Anxieties surrounding the European banking system might have an impact on demand and might actually do some of the work that might otherwise be done by monetary policy, Lagarde said just days after two major U.S. banks collapsed and the Swiss banking giant Credit Suisse required a rescue by its rival UBS.

Indeed, if Europe were to experience a credit crunch, analysts say, last weeks ECB rate hike might be its last for a while.

ECB officials have said their banks are resilient and have strong enough capital buffers and cash to cover whatever deposit withdrawals they face. European supervisors have applied international standards, requiring more ready cash on hand. By contrast, U.S. regulators exempted all but the very largest U.S. banks. Silicon Valley was one of those banks.

And when loans are more expensive and harder to qualify for, consumers, who drive most of the U.S. economys growth, are less likely to spend.

Gregory Daco, chief economist at the consulting firm EY-Parthenon, said he thinks a significant credit squeeze would have slightly more of an economic impact than the quarter-point rate hike the Fed announced Wednesday.

Edward Yardeni, an independent economist, said he would estimate that the impact would be even larger the equivalent of a full percentage point hike by the Fed.

Inflation could slow as a result, helping the central bank accomplish its long-standing goal. But the the toll on economic growth could be substantial, too. Most economists have said they expect a recession to occur in the United States by the second half of this year. The main question is how severe it might be.

Signs of a possible credit crunch in the United States had begun to emerge even before Silicon Valley Bank collapsed on March 10, raising worries about the stability of the financial system. In the face of rising rates and a deteriorating economic outlook, banks were already becoming stingier about approving loans to businesses at the end of 2022, according to a Fed survey of bank lending officers.

And bank commercial and industrial loans to businesses dropped last month for the first time since September 2021, according to the Fed.

Since then, the stress on banks has only grown. Silicon Valley Bank, which had been the nations 16th biggest bank, failed after accumulating huge losses on its bond portfolio that led worried depositors to withdraw their money. Two days later, regulators shut down New York-based Signature Bank.

The Federal Deposit Insurance Corporation, which insures bank deposits up to $250,000, said that banks were sitting on $620 billion of paper losses in their investment portfolios at the end of last year. That was largely because higher interest rates had sharply reduced the value of their holdings in the bond market.

Powell declared Wednesday that the banking system is sound and resilient. Yet fear remains that more depositors will pull their money out of all but the biggest American banks, intensifying pressure on financial institutions to lend less and conserve cash to meet withdrawals.

Banks with less than $250 billion in assets account for about half of all business and consumer lending and two-thirds of home mortgages, noted Mark Zandi, chief economist at Moodys Analytics.

Credit is really the grease that oils the U.S. economy and allows it to function and grow at a stable pace, Daco said. Without credit or with slower credit growth were likely to see businesses be more hesitant when it comes to investment decisions, when it comes to hiring decisions.

A tightening of bank credit, he said, noticeably increases the risk of a recession.


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