As I read through the recent news and analyses on the Federal Reserve's decisions and actions, I can't help but feel a sense of unease. It seems like we're caught in a precarious balancing act between inflation and financial stability, and none of it is heading in the right direction. The Fed's persistent rate hikes in the face of a full blown financial crisis indicate their concern about inflation, but with labor markets still tight and the potential for more financial sector turmoil, it's unclear what their next steps will be. As someone who closely follows economic news and trends, I can't help but feel like we're in for a rocky road ahead.
It seems that many people were fixated on the idea that interest rates will continue to rise and stay high for an extended period of time due to concerns about inflation. However, this perspective seems to ignore a critical factor: the economy's dependence on cheap debt. Over the past decade, the economy has been propped up by historically low-interest rates, which have enabled individuals and businesses to take on more debt than they otherwise would have. As a result, any significant increase in interest rates could have severe consequences for both the financial sector and the broader economy.
Furthermore, what people don't understand is that the government's debt burden will also increase when interest rates go up, leading to higher interest payments on its outstanding debt. This, in turn, will put pressure on the government to either cut spending or raise taxes, both of which could potentially slow down the economy, but neither of which will be significant enough to help with the US's debt spiral. The current system is built on a foundation of cheap debt, and if that foundation is disrupted, the entire economy could be thrown into chaos.
These issues highlight the need for careful consideration of monetary policy decisions, at this point. The Fed must balance concerns about inflation with the potential consequences of raising interest rates too much more from here. Any more increases in interest rates from here could easily cause widespread financial turmoil and economic hardship, particularly for those who have taken on significant debt. As such, it's important to approach interest rate decisions with a clear understanding of the broader economic context and to make careful, data-driven decisions that take into account the potential consequences for all stakeholders.
"Anything that happens in the US doesn't stay in the US. It transmits across the world."
Inflation and Financial Stability
The Fed is facing two main challenges at present – inflation and financial stability. They would obviously prefer to have only one issue to deal with, but unfortunately, both issues require attention. With the US labor market still being tight, the Fed is concerned about inflationary pressures, and as a result, has recently raised interest rates by 50 basis points. I believes that the Fed will not cut rates to zero, but instead opt for a 25 basis point cut, as this still signals that they are concerned about inflation and need to slow down the economy. I personally think this is a move to flex their muscles and beat a dead horse. Because of all these rate hikes, I am calling that they will likely result in an emergency rate cut to come.
Financial Sector Turmoil
The second challenge facing the Fed is financial stability, which can be impacted by sector turmoil. The financial sector will likely handle some of the Fed's work by making businesses more willing to lay off people, thereby contributing to slowing down the economy. However, this is not the ideal way for the Fed to operate. If financial sector turmoil increases before the Fed's next meeting, it may lead them towards a zero cut.
Implications for the World
As the US economy affects the rest of the world, people are understandably concerned about the extent of the current problems. The systemic risk in the US lies in the interest rate risk exposure of small and medium banks. The world wants to know how many banks have this kind of exposure and whether any large banks are at risk. Unfortunately, I think the practice that got Silicon Valley Bank in trouble wasn't much different then what all bank had to do to create yield. Let's also not forget that the government gave us all a great reason to move our money into larger banks, creating an interesting upcoming year for small to midsize banks.
Economic Landing
The potential for a soft landing in the US economy seems remote, and the chances of a moderately hard or really hard landing seem more likely. If inflation remains high, the Fed may increase rates, which could lead to layoffs, causing a fall in house prices, and ultimately, a harder landing than the Fed intended. Alternatively, if financial sector concerns increase, people may rein in their spending, leading to a slowing of the economy. This scenario would cause the Fed to slow down without having to increase interest rates.
Conclusion
The Fed is currently facing two significant challenges, inflation and financial stability, and needs to navigate them carefully. While it would prefer to deal with only one issue, both require attention. The financial sector can play a role in helping the Fed with its work, but this is not an ideal situation. There are concerns about how many banks have the interest rate risk exposure that poses a systemic risk in the US, as well as how many small to mid-size banks will now see a mass exodus of depositors. Get your popcorn ready. This is all just starting to get interesting.
By Eric Johnson, Full Time Investor & Co-Founder of Elevation Equities