Stocks took a beating yesterday as regional bank stocks collapsed. Oil prices fell sharply sending that sector down as well. Yesterday was the start of a 2-day FOMC meeting. It will conclude this afternoon. All signs suggest the Fed will raise interest rates by another 25-basis points despite the turmoil in the banking sector and a looming debt ceiling crisis that could lead to default on government debt on or after June 1 according to Treasury Secretary Janet Yellen. This could happen before the next FOMC meeting in June.
Let’s examine the reasons to continue raising rates. Both inflation and economic growth rates have been stronger than anticipated despite all the rate increases since the Fed started hiking in March 2022. Inflation is still above 4%. Wages are still rising by more than 4%. GDP rose by more than 1% in the first quarter. Employment has been rising by more than 200,000 jobs per month. The economy, at least looking backwards at the reported data, is simply too strong to allow inflation to drift down to 2%, the Fed’s target. Indeed, according to this logic, not only is an increase in rates necessary today, but additional increases might be necessary in the coming months.
Now let’s look at the other side. The Fed’s mandate is to maintain price stability and employment growth. While inflation, as reported, is still too high, it is coming down. Shelter costs, the most important component of all inflation indices, are still rising at a pace of over 7% according to reported data, far higher than real time data suggests. In addition, energy costs are dropping sharply. Oil is down below $70 per barrel and natural gas prices have fallen even more sharply. The direct impact is generally pulled out of inflation data to look at core inflation, but lower energy translates into lower transportation, manufacturing and operating costs. Inflation is declining. One can only argue the pace.
Interest rate increases work with a significant lag. While the Fed Funds rate is still below 5%, at least until this afternoon, the prime lending rate of most banks is now 8%. Borrowing is already expensive. Companies want to lower borrowing costs. To do so, they cut back where they can and reduce inventories. They let payables run as much as they can. Bank lending is down. QT, where the Fed reduces its balance sheet by close to $100 billion per month, works to flush excess cash out of the banking system. High rates shift excess deposits into Treasuries or money-market funds. Money flows from small banks to large banks. Many smaller banks need the deposits to support their lending activities. Larger banks don’t need the excess deposits. The shifts in deposit flows aren’t helping anyone. Smaller banks will have to raise lending rates and fees to compensate for added costs, including the need to pay depositors more to keep money at the bank. All banks will have to pay higher deposit insurance fees for the costs the FDIC incurs taking over failed banks. SVB cost the FDIC more than $20 billion. First Republic cost $13 billion. The costs are to be recovered via higher insurance premiums. Now there is talk of raising deposit insurance levels to $500,000 for commercial customers. Guess who is going to pay for that? Ultimately, it’s you and me. Obviously, the increase in fees and borrowing costs are either going to be passed on to the customers (I think we call that inflation!) or it will be eaten by the banks showing up in lower profits. No wonder the prices of bank stocks are falling.
There may be other failures. It appears the next in line after First Republic is PacWest. Will that fail too? It’s too early to tell, but there will always be a “next in line” until regulators and Congress realize there is a systemic problem and something is done to release the pressure. No bank can withstand a run.
I haven’t even mentioned the debt ceiling crisis yet. This week Treasury Secretary Janet Yellen said the nation could default as early as June 1 if the debt ceiling isn’t raised. House Republicans have passed a bill to extend the ceiling in conjunction with steps to lower net future spending. Democrats in the Senate and the White House so far have refused any effort to increase the debt ceiling if spending cut requirements are attached. Welcome to bifurcated Washington where everyone says “my way or the highway” and no one listens. Obviously, that will change as the actual ceiling date approaches. Should there be a default, there is sure to be economic turmoil. While the White House hasn’t said how it would deal with a situation that is reached where no further borrowing can be done, it is unlikely the first step would be to default on debt or interest payments. More likely would be a deferral of pay for Federal or military personnel, or a temporary reduction of Social Security payments. Steps like these would lead to a crisis solution within days. It would also leave lots of scars. Every incumbent holding political office would be held accountable. No one wants that. Right now, no one knows how to avoid that.
Thus, the Fed is caught between two obvious crosscurrents. On the one hand, its principal battle to fight inflation seemingly requires more ammunition, at least one more rate increase. On the other hand, financial markets are starting to destabilize, bank deposits are drifting away, a recession looms, and a debt crisis could erupt before the next FOMC meeting.
In the back of every Fed official’s mind is the reminder of what happened in the 1970s when inflation ran completely out of control. Repeated tightening steps taken by the Fed brought inflation down, but only temporarily. Subsequent recoveries saw inflation rise to new heights.
The culprit wasn’t that the Fed failed to bring inflation down. No, the villain was the sustained expansions that followed. The Fed persistently and repeatedly stayed with easy money policy too long. Not only did the Fed do that in the 1970s, it repeated the same mistake persistently in the 1990s (remember “irrational exuberance”?), leading to the Internet bubble in the 2000s, leading to the mortgage crisis, and most recently, leading to the surge in inflation we are experiencing now. Crisis times call for easy money. When the crisis ends, so should easy money. It is a lesson the Fed has failed to learn for over 50 years. It is hard for policy makers to put the lid on the cookie jar and slow the pace of economic growth to one that is sustainable and inflation free. Instead, it waits for a bubble and then is forced to slam on the brakes.
Here’s the bottom line. All indications are that the Fed will raise rates 25-basis points today. Its post-meeting language will suggest that it is at or near the end of its rate hiking cycle. There will be no promises of a pause, but hints that one could happen, subject to datea between now and the next FOMC meeting in June. While that is the expected outcome, it is the wrong one. There is absolutely no logic, given the fragility of the regional banking system at the moment and the threat of a debt default before the next meeting, that the Fed shouldn’t stand down, now noting that it could resume raising rates this summer if necessary.
The Fed wants to show it is tough. It can do so by not suddenly reducing rates back toward zero. It’s not what it does to slow the economy down; it’s what it does once a recession ensues. Will it revert to past practices and overstimulate for too long? If it wants to look tough, put the lid back on the cookie jar much sooner. The demographic reality, both in the U.S. and around the world, is that economic growth rates are going to be lower in the future than they have been in the past. Slower population growth means slower economic growth. Any attempts to stimulate faster growth will simply reignite inflation. The Fed doesn’t control the birth rate or the pace of immigration. Those are the ultimate determinants of growth.
Markets may expect a rate increase today, but they won’t like it. More than likely GDP growth in Q2 will fall toward zero and be negative in the second half of the year. That presumes no serious banking turmoil and no serious debt default crisis. A rate increase today might do minimal further damage, or it could be a tipping point toward greater turmoil. We won’t know until after the fact. The Fed will try to appease investors if it increases rates, by hinting that the cycle of rate increases is near an end. But no one knows what will happen six weeks from now at the next meeting. Reality is that the Fed is data dependent. Chairman Powell has said that multiple times, but data is always backwards looking. It measures what happened yesterday, not what will happen tomorrow. That is why the Fed is always late, late in raising rates, and late in pulling them back. Lowering rates stimulate and markets rise knowing the future will be brighter. Raising rates means tougher times ahead. Markets can deal with that but they don’t deal with turmoil well.
One last thought related to QT, the process whereby the Fed reduces its balance sheet by $1 trillion per year. At the start of the process, it’s a good idea siphoning off excess cash that feeds inflation and speculation. But once the excess is absorbed, it starts to lower growth and tighten financial conditions. Lowering growth is OK, part of defeating inflation. Reducing discretionary spending slows growth and defeats inflation. Reducing spending on necessities creates undue hardship. It can lead to conditions so tight that markets stop behaving normally. The size of the Fed’s balance sheet is irrelevant, but changes are relevant. Reducing it by $1 trillion per year adds $30-40 billion to our nation’s debt service requirements. It reduces money supply by an equivalent amount. It’s helpful when excess money is sloshing around. It’s harmful when there is no excess. Once again, the Fed won’t know it’s at the tipping point until after the fact if it simply relies on backwards-looking data. The problem today is that money is flowing out of the banking system into alternatives (e.g., money market funds). To the extent there is still excess, it is now concentrated in the four largest banks. I doubt there is a bank today beyond the four largest that will tell you that it has a problem with excess deposits.
Look for turmoil following today’s Fed meeting.
Today, actor Bobby Cannavale is 53. Ron Hextall is 59. Toyota President Akio Toyoda is 67.
James M. Meyer, CFA 610-260-2220