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April 2023: Thoughts on the economy
Things are getting rockier
Over the last year, the Fed has been raising interest rates at a brisk clip to counter the high inflation that began in the wake of the Covid recession. The idea behind this is straightforward; if interest rates go up, then it will be more expensive to borrow money (as any would-be homeowner can tell you), so businesses will borrow less and it will put a damper on the economy. After a slow start, the Fed was moving quickly. Rates have gone up from 0.25% to 5.00% in a little over a year. The problem, however, is this:
It hasn’t worked. At least not yet. The above graph shows the PCE, the Feds preferred measure of inflation. The Fed target is two percent, and despite a year of rate hikes, the PCE is still over double that target. Under normal circumstances, the Fed would be expected to continue to raise rates until, at the very least, the PCE started to show steady downward momentum. I don’t want to trivialize how difficult this is. Changing interest rates to shift inflation is like turning a ship’s helm on a giant barge during a storm. If you turn the wheel all the way to the right the ship will start to turn eventually, but then it will turn too far and you’ll have to do a counter-correction. Steering a giant ship in the middle of a fierce storm is difficult enough, but at least the ship and water will obey the laws of physics. The economy, on the other hand, is not nearly as predictable. So the Fed should be increasing rates somewhat cautiously, and as soon as inflation starts to decrease along a similar trend that it increased in 2022 the Fed should stop increasing rates and maybe even decrease them.
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Then came the failure of Silicon Valley Bank (SVB), which I discussed here and here. Despite being just the 16th biggest bank in the US, and one that was unique in a lot of ways, this has thrown a massive wrench into the Fed’s plans. Banks, just like other businesses, may also be harmed by the increase in rates. Specifically, banks that invested a lot in treasury bonds over the last few years could be in trouble if rates go too high.
This is because 10-year treasury bonds were paying less than 1% interest in 2020. Now they are paying close to 4%. Why is this a problem? Because when banks need to raise capital, one way they do so is by selling their treasury bonds. But if you were to buy a treasury bond right now, would you rather buy one issued in 2020 that pays 1% interest or one issued last month that pays 4% interest? Obviously the latter. The only way you would buy the 1% bond from 2020 is if the seller was willing to give you a discount. This is what SVB did, and it’s why investors got spooked. Why would SVB sell $20 billion in treasury bonds for only $18 billion? They must be in trouble. Everyone panicked and withdrew their money and the bank failed. The fear now is that if the Fed keeps on raising rates, this could happen to other banks as well. Ironically, this is partially because banks were actually being cautious. Treasury bonds are supposed to be a risk-free place for banks to park depositors’ money. That is true unless the bank needs to sell those bonds to raise funds. Because of this I’m skeptical that “greed” is a major component of current banking issues. Greedy bankers generally don’t think, “I’ll risk lots of money and try to become richer by buying treasurey bonds!”
So now the Fed has to balance two issues that are diametrically opposed to one another: getting inflation under control and preserving the health of the banking system. So now our ship at sea during a storm has a small fire on board as well. It’s up to the Fed to decide how to allocate resources. The higher interest rates go, the more stress on the banking system. If interest rates stay the same or are decreased, then inflation will be higher. Perhaps the only good news is that instability in the banking sector could cool inflation on its own if consumers get spooked and reign in spending a bit, but that’s pure conjecture.
There’s also no “right option” here, as either course will have winners and losers, and there’s a great deal of uncertainty. The Fed has already increased emergency lending to banks; this will help them borrow money at very low rates and avoid selling treasuries at a loss. It is entirely possible that with this new lending plan, the Fed could continue to raise rates and no new banks would fail. It’s also possible, however, that unless the Fed lowers rates, additional banks will fail, and that could push us into a strong recession. So the Fed is hopefully hard at work stress testing the 10th-25th biggest banks to see what increased interest rates would do to their balance sheets.
Currently, markets appear to be expecting either a 0.25% increase or no increase at the next Fed meeting. If the Fed continues to increase rates, that will help with inflation and will hopefully bring the economy back into balance, but could contribute to a banking crisis. If they leave rates the same, that would help the banks out but would make continued high inflation more likely.