By Tim Courtney, Chief Investment Officer
The Federal Reserve’s latest rate hike of 0.25% comes in the face of an increasingly difficult challenge to control inflation. We’re using higher interest rates as medicine to cure inflation that was caused by 0% interest rates. The medicine has side effects. Raising interest rates too high might bring down prices (see housing) but also cause layoffs, lower consumer spending and potentially a recession. The higher rates also began exposing weak links in the banking sector.
Earlier this month, Fed Chair Jerome Powell spoke before Congress, stating rate hikes will stick around, indicating that borrowing costs for everyone, including the government, will remain high for longer. This news came as interest payments on the national debt reached an all-time high of $475 billion in fiscal year 2022, with projected growth of another 35% in 2023.1 However, shortly after those comments we saw the collapse of Silicon Valley Bank and Signature Bank, leading to fear and instability in the banking sector.2
The banking crisis further complicated the Fed’s quest to cure inflation, which was already up against political pressures and other issues out of its control. For example, lockdowns during the pandemic created massive layoffs and, as the world reopened, people were slow to return to work with many looking for remote or part-time work, leading to decreased output and a lower supply of workers (inflationary).3 We’ve also experienced supply chain issues as a result of pandemic shutdowns, and as a result companies are reversing a decades long process of globalization. This reshoring will likely be an inflationary force regardless of interest rates.4
Given all these pressures, we are likely going to find ourselves having to pick the least harmful path forward. Higher rates will eventually tame much of the inflation we’ve witnessed over the last year, but at a cost of higher government debt to the taxpayer and increasing odds of a recession. This is especially the case now that regional and smaller banks are almost certain to begin reducing lending. Lower rates may help the calm markets in the near term and make politicians happy with low cost borrowing, but inflation will likely remain elevated and could become even harder to slow. The market had hoped for lower rates but this is now this may not happen until next year.5
Of all of the potential paths, perhaps the middle path is the one we’ll land on. This means rates won’t quickly reverse and will cause pain with higher borrowing costs/slower growth but that are close to peaking before a slow move lower. This also means inflation that continues contracting but remaining higher than the Fed’s 2% target. While interest rates are a key tool in lowering inflation there are other inflationary variables that rates can’t affect.
As we’ve noted, the markets continue to work through the distortions caused by the pandemic and policymakers in 2020-2021. The Fed will come under increasing pressure from borrowers and the economy to lower rates. It remains under pressure from consumers to control inflation. We may very well end up with a solution in the middle where neither side gets exactly what it wants. For us as investors that means respectable interest rates but slower growth and no multiple expansion fueled market runs like 2020-2021. For us as consumers it means falling but elevated inflation. If you have questions, please contact your Exencial advisor.
Sources:
- Peter G. Peterson Foundation (2/16/23) — Interest costs on the national debt are on track to reach a record high
- CNN (3/20/23) — Global banking crisis: What just happened?
- NPR (3/10/23) — The job market slowed last month, but it’s still too hot to ease inflation fears
- Financial Advisor Magazine (10/7/22) — Why deglobalization makes U.S. inflation worse
- CNBC.com (3/13/23) — Something broke, but the Fed is still expected to go through with rate hikes
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