Fed Hikes - What a Mess

Dan North | March 2023

Recently, the Federal Reserve took yet another shot at inflation, raising the overnight Federal Funds rate by 0.25% to a range of 4.75% to 5.0%. The Fed has raised the rate at every one of its last nine meetings.

We now believe that the most likely path from here will be one more 0.25% hike at the meeting in May, a pause for some time, and rate cuts later in the year. By contrast, the Fed is adamant that there will be no rate cuts this year at all, and on the opposite end of the spectrum, the Fed Funds futures markets see a cut as early as July.

A key phrase in the accompanying statement signaled a possible slowing in the Fed’s rampage against inflation. For months the statement had been reading “…ongoing increases in the target range will be appropriate…” but at this meeting, it was changed to “some additional policy firming may be appropriate…”

If that’s signaling that the hiking cycle is nearing the end, it’s about time. The interest rate hikes are taking their toll:

  • Most inflation measures have peaked.
  • Leading indicators are overwhelmingly pointing to recession.
  • Economic growth is stalling:

      •  Personal consumption has fallen two out of the past three months

      •  Retail sales have fallen three out of the past four months

      •  The housing market is shattered

      •  Manufacturing is in a recession

      •  The labor market is weakening

Perhaps most importantly, the interest rate hikes so far are a long way from having their full effect. The chart below is a conceptual diagram. Changes in monetary policy take three to five quarters to work through the economy. So that arrow shot last March, that 0.25% rate cut, is probably only now having a full effect on inflation. The most recent three or four probably haven’t done much of anything yet… but they will. That’s why the leading indicators are screaming recession.

And yet, the Fed seemed to ignore all that and hiked right into the teeth of a banking crisis.

The Fed has a very bad habit of raising interest rates too far when it is fighting inflation. In those situations, the Fed is loath to pause or cut rates too soon for fear it hasn’t completely extinguished inflation. By then it’s too late for the economy, which goes into recession. And this sequence of events is almost always accompanied by an extra unfortunate event - the Fed always raises too high until something explodes – like the current banking crisis. The first chart below is a 35-year history showing a clear pattern, while the second chart goes back 108 years.

So here’s how the Fed got us into this current explosion. First, it set short-term interest rates to 0% for too long. That forced banks, which hold Treasury securities as assets, to buy long-term securities which paid a little more interest. Then the Fed started raising rates, and the value of those securities fell (bond prices and interest rates move in opposite directions). In the case of Silicon Valley Bank (SVB), depositors had been pulling their funds out for some time, and to cover those withdrawals SVB had to sell those Treasury securities… now at a very steep loss. The bank could no longer cover withdrawals and was shut down. The concern now is that small regional banks may be in the same situation, that is they might not be able to cover withdrawals because they don’t have enough money because their securities dropped in value so much. (Really, SVB should have seen this coming. It’s plain poor management).

So now the Fed, which created the problem, has come riding to the rescue with two new emergency bank lending programs, the Bank Term Funding Program (BTFP), and a program to support the FDIC which is insuring all those depositors who might want to withdraw their money. In addition, banks have been borrowing from the Fed at the “discount window”, a facility banks normally don’t use unless there is trouble. Apparently, there is trouble. The first chart shows that discount window borrowing now well exceeds borrowing during the global financial crisis. Note on the chart that most of the time, borrowing at the discount window is $0, again, unless there’s trouble. The second chart shows borrowing at the discount window, the BTFP, and the FDIC programs over the past three weeks. That is a lot of money being borrowed by banks and it’s worrisome – are they borrowing because they have to clean up their balance sheets, or do they sense a storm coming, or both?

Note that almost all the worries are focused on smaller regional banks, not on the big four that are too big to fail – Citibank, Wells Fargo, J.P. Morgan. and Bank of America. But as a whole, smaller banks are very important to the economy. The charts below show that they make up a sizable portion of credit and assets for all banks and that they account for 80% of commercial real estate lending and 50% of Commercial and Industrial (C&I)  loans.
The stock market is clearly nervous about the situation. A basket of regional bank stocks (KBW Regional Banking Index) is down about 23% since February 21st whereas the S&P 500 is down only 1.2%, and one of the regional banks, Zions is down 45%. Beleaguered First Republic (not shown) has lost about 90% of its value.
Just a reminder of how much rates for mortgages and credit cards have risen since the Fed first signaled it was going to raise rates – what a drag. Credit card rates are now at an astounding record high of 19.1% on average, and rates can be much higher for those with poor credit.
And of course, that’s not only when rates started climbing higher, it’s when banks started tightening their lending standards, as shown in the two charts below. Note that this data is from three months before the banking crisis – banks are going to get a lot stingier with credit. And if credit to businesses and consumers dries up, well it’s just another nail in the economy’s coffin.