(Bloomberg) -- A banking crisis in a matter of days has emerged to potentially choke off a red-hot economy, raising the odds of a recession that the Federal Reserve has been working to avoid.

Rattled by runs on regional US banks and wild gyrations in stocks and bonds, bankers abandoned attempts to raise new funding for their corporate clients. Not a single investment-grade company sold bonds in the US market last week, marking the first sign of what’s set to be a broad-based hit to the provision of credit across the economy.

A rush for safety outside of banks spurred the biggest weekly inflow to money-market funds since April 2020. And with data on Friday showing deposits were already sliding in the run-up to three US bank collapses, the pace of lending to companies and households alike is bound to shrink, economists said.

Global strains pose another concern, as investors monitor the consequences of Credit Suisse Group AG’s downfall and takeover by UBS Group AG. Speaking to the level of worry, the Fed over the weekend moved to ensure a sufficient supply of dollars overseas by re-starting crisis-era currency swap lines with key counterparts.

As Fed Chair Jerome Powell and his colleagues gather Tuesday for a pivotal two-day policy meeting, the question is whether the brakes have been suddenly slammed too hard. The central bank wanted a slowdown — something seen as essential to tame inflation — but not a crisis capable of sinking the economy into a deep recession.

“The balance of risks have shifted,” said Daleep Singh, chief global economist for PGIM Fixed Income and former markets chief at the Federal Reserve Bank of New York. “The risks from too much tightening are now at least equal to — and likely larger than — the risks of doing too little.”

Ditching a March 22 rate increase would give the Fed the chance to gauge the seriousness of the current turmoil, and the effectiveness of the steps it’s taken to shore up banks’ liquidity. 

But that strategy also could risk spooking the public into thinking the central bank sees a major systemic crisis under way — a danger that convinced the European Central Bank on Thursday to go ahead with its own rate hike. An additional concern: if the crisis fades, failing to act in March could further entrench inflation.

What makes things all the more complicated for Powell and his team is that they’re also due to release updated projections for where they see the benchmark rate at the end of 2023 and 2024. Those are updated every quarter, and on this occasion come on the heels of the second-biggest US bank failure in history.

Singh predicts the Fed will raise its benchmark by 25 basis points, bringing the target range to 4.75% to 5%. He then expects Powell to signal rates will be on hold for the time being.

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Despite the Fed’s moves a week ago to ring-fence the broader banking sector from the meltdown of Silicon Valley Bank, last week saw an exodus of deposits from smaller and regional banks and toward larger brethren. Bank of America Corp. mopped up more than $15 billion in new deposits in a matter of days, Bloomberg reported Wednesday.

In another sign of emergency demand for funding, banks borrowed a combined $164.8 billion from two Fed backstop facilities in the most recent week, a report showed Thursday.

With bank shares tumbling, Nomura Holdings Inc. economists last week went so far as to predict the Fed would cut rates by a quarter percentage point and abandon its quantitative tightening program — the runoff in its giant bond portfolio.

While Deputy Treasury Secretary Wally Adeyemo said on Friday that, based on discussions regulators have had with banking executives, deposits at small- and medium-sized banks across the country had begun to stabilize and in some cases “modestly reverse,” economists are broadly anticipating a pullback in credit.

Smaller-sized lenders account for a disproportionate share of overall lending to companies and households, amplifying the impact of their recent woes.

Among some of the calculations that analysts made last week:

  • Slower loan growth from mid-sized banks could shave somewhere between a half point and a full percentage point off of GDP growth over the next year or two, according to Michael Feroli, chief US economist for JP Morgan Chase & Co.
  • Goldman Sachs Group Inc. economists estimated that tighter financial conditions could lop half a percentage point off US growth this year.
  • UBS Group AG estimated that smaller and regional banks hold about 18% of US debt, including some 39% of commercial real estate (CRE). Tends in CRE, small and medium enterprises and credit cards will be “leading indicators of a broader credit crunch,” strategists led by Matthew Mish wrote.

A Bloomberg Economics model indicated late last week that the market-induced financial tightening, if sustained through June, amounted to the equivalent of 50 basis-points in Fed rate hikes over the rest of 2023.

Bloomberg Economics: US Faces 0.3% 2023 GDP Hit if Stress Stays High Through Q2 

“If the turmoil subsides in the next few weeks, however, the impact will be minimal,” said Anna Wong, chief US economist for Bloomberg Economics. “Our base case is somewhere in between those two scenarios, with the adverse impact equivalent to a 25 basis-point hike.” 

US INSIGHT: How Many Fed Hikes Did SVB and CS Stress Replace?

Torsten Slok, Apollo Global Management’s chief economist, sees a much bigger impact from the recent turmoil — calculating that the financial tightening amounts to a 1.5 percentage-point jump in the Fed’s benchmark rate.

The irony is that the sharp tightening in credit now underway is exactly what the Fed had been seeking to cool a job market that recently saw the lowest unemployment rate in more than half a century — generating wage pressures that are keeping inflation far from central bankers’ target.

Last week, the Fed got fresh evidence of the limited impact of its year-long rate-hiking campaign, when data showed underlying US consumer prices rose in February by the most in five months.

“Powell doesn’t want to look like this turmoil has derailed him from fighting inflation — and he hasn’t gotten any good information on inflation that could suggest it’s time to take a pause,” said Ellen Meade, an economics professor at Duke University and former senior Fed staff member. At the same time, “without a doubt there is going to be some pullback in lending,” she said.

It all makes for an exceedingly difficult set of forecasts for the Fed’s Summary of Economic Projections report, which will be released alongside the policy decision on Wednesday. Fed governors and bank presidents will each submit forecasts.

The median prediction in December showed a 5.1% policy rate for year-end — a level that Powell said at a March 7 congressional hearing would likely be raised thanks to stronger-than-expected economic data.

But that was before the SVB collapse.

“In words, they can explain the quandary that they have right now,” said Meade. “The numbers in the SEP are a little harder.”

--With assistance from Jill R. Shah.

(Updates with Credit Suisse context in fourth paragraph.)

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