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#50: Now, how long can they hold...
A year into the hiking cycle and we have nearly reached the top. The market odds suggest that another 25 basis point rate hike is probable at the upcoming May FOMC meeting. If the Federal Reserve does go through with the hike, it will likely be the last.
The Fed is ready to pause - it has told us on paper and between the lines. The most recent Summary of Economic Projections (SEP) released in March indicates a terminal rate of just over 5%, suggesting one more quarter-point hike this year. Meanwhile the posturing of the Fed has been gradually softening in a deliberate and choreographed way since late 2022. First stepping down from jumbo-hikes, then cheerleading “disinflation”, the Fed is now finally ready to use the P-word.
Of course, a pause will be delivered with cautionary language about long and variable lags, data dependence, and the ongoing war on inflation. But the message has been clear for some time.
With year-over-year headline CPI inflation at 5.0%, core inflation at 5.6% - more than twice the Fed’s target - is pausing a mistake?
Not necessarily. In fact, it might just be prudent.
Throughout this column, we have explained the current bout of inflation in fairly “monetarist” terms - focusing on the growth in money supply compared to availability of goods and services to determine price. This isn’t because of an ideological preference towards a certain economic model, but rather because it is the most obvious explanation of the current situation. The massive expansion of money during the pandemic is the four-ton elephant in the room.
Here is the economy in a chart.
Demand deposits - the most liquid form of money other than currency, and perhaps a better inflation indicator than M2 - shot higher over the pandemic, and remains three times higher than early 2020. The Fed printed money and the Treasury handed it out.
For some reason, this feels weirdly taboo to say explicitly. Perhaps because of differing political and economic perspectives or because of some implied moral undertones, we struggle to state the plain fact. People have more money - much more money - than they used to1. It doesn’t matter how you feel about it (or the policies that caused it), it is true.
From this starting point, many things that may seem odd start to make sense. Consumer balance sheets improved dramatically. Spending and real economic growth far exceeded most expectations. Corporate earnings grew by 30%. And we have seen the highest inflation since the 1980s.
This was a grand experiment in monetary and fiscal policy and history will be judge of its effectiveness. The purpose of emphasizing pandemic policy as the primary driver of inflation is not to finger-wag at handouts or grandstand about debasement, but rather because diagnosis informs prognosis.
More money was a policy decision that is being partially unwound via quantitative tightening (QT). Broad money supply is now shrinking. Demand deposits have finally plateaued after tripling. A strict monetarist would expect inflation to come down fast if money stops growing and starts shrinking.
And inflation has come down meaningfully from the peak. With energy set to push down headline CPI over the next several months and shelter inflation finally showing some reprieve, the official scoreboard is set to show more progress in the coming months.
At most, low interest rates played a secondary role in driving inflation. Bank loans were flat from early 2020 to mid-2021, by the time CPI inflation already exceeded 5%. It also appears that current interest rates are restrictive. Lending standards are tightening and credit growth has been trending downwards for months and is now verging on contraction2. Rate cuts would likely reinvigorate credit growth and could add to inflationary pressures, but the current policy seems to have already achieved its objective.
To the extent that inflation remains stubborn and sticky, it is more likely due to past policy than current dynamics, as the economy finds the new equilibrium of supply and demand. That is the tradeoff that was chosen during the pandemic - and there is no easy undo button. Pushing rates even higher is the wrong lever and risks a more severe credit crunch with damaging economic effects.
Now forget all that junk about inflation, the real reason the Fed will pause is financial stability.
The Fed doesn’t really care about inflation, or at least not as much as they suggest. It made this explicit by adopting an “average inflation target” in August 2020, allowing policymakers to consciously overshoot the 2% target. Then, the Fed doubled the monetary base and oversaw a 25% year-over-year increase in money supply. The Fed held rates at zero while pumping $120 billion of QE into financial markets monthly while CPI skyrocketed. Inflation was a risk they were willing to take. The fight against inflation was begrudging and belated.
By contrast, the Fed is terrified by financial stability. The Fed slowly tapered QE for months out of fear of upsetting bond markets.
When forced to choose between the two, financial stability wins every single time. Case in point, Powell teased the possibility of a 50 basis point rate hike in early March due to strong inflation in January. Weeks later, the Fed almost scrapped the rate hike altogether! The inflation data didn’t change, but a bank collapsed.
Opinions vary on the scope and severity of the banking crisis, but there is no doubt that Silicon Valley Bank failure caught Fed officials off guard (and scared the heck out of them). And while SVB may have been mismanaged, there is a direct line between monetary policy and the banking crisis which are not isolated to bad actors. Bond portfolios have taken losses with higher rates and QT is draining deposits and bank liquidity.
Some have declared the banking crisis over since there hasn’t yet been failure in the past month and discount window borrowing has declined, but that seems both premature and a very low bar for an “all clear”. I can guarantee that Fed officials are not comfortable with the banking sector so long as they have $140 billion outstanding between the discount window and Bank Term Funding Program (BTFP).
Total bank deposits have been shrinking at an unprecedented rate for more than a year and deposit flight accelerated strongly in the past month. QT continues to shred liquidity. Delinquencies and charge-off rates are increasing. The reverse repo is at all-time highs (excluding quarter-end turns) and has yet to provide the liquidity support the Fed expected it would. The Treasury General Account will need to be refilled soon. All of these issues have been brewing long before SVB failed, and will continue to put stress on the financial system going forward.
They say that the Fed hikes until something breaks. Something finally broke, and unless there is a change to policy, more things will eventually break too. The pause is coming because the current path is unsustainable.
As it is, banks are benefitting from the market’s expectation of rapid rate cuts, as the entire US Treasury curve is deeply inverted. Yields on the U.S. 10-year peaked all the way back in October, which has helped reverse some mark-to-market losses on bond portfolios. But if the curve reprices upwards, we could see significant stress resurface even without further hikes to the Federal Funds rate.
So, if the Fed is pausing, does that mean it’s time to buy?
The market expectation is for a 25 basis point hike on May 3rd. If the Fed pauses instead, which is very possible, it would be considered dovish and may give markets a boost. But the terminal rate has been well telegraphed for some time, and really the Fed would just be fulfilling expectations. In other words, the pause is less of a pivot and more of a follow-through.
A bigger question isn’t whether the Fed will pause - but rather how long it can hold. The Fed will try to convince the market that it is holding as long as it takes and will stress data-dependence and a wait-and-see mentality. How long the Fed actually holds is likely to depend on underlying economic momentum throughout the remainder of the year.
While I have been loath to predict a U.S. recession due on the continued strength of the consumer, there are some more tangible dark clouds forming. The labor market is certainly softening (though far too early to call it soft). Recent real-time spending data from multiple banks have shown a notable drop in spending in March. Delinquencies have picked up from historically low levels. The growing pile of money that has turbocharged consumers for the past several years seems to have finally plateaued.
But history suggests that the pause in a rate hike cycle usually precedes a recession by about a year, and I do believe the Fed will be more reluctant to cut rates prematurely given the uncomfortably high inflation.
More broadly, buying equities on the Fed’s pause has surprisingly mixed results. Recessions tend to hurt stocks eventually, but big gains can happen in the interim. In 2000, the Fed’s pause coincided with the market top. In 2006, the S&P 500 would gain another 25% after the Fed paused before cratering in the Great Recession. Stocks loved the 2018 Powell Pivot, gaining 43% before the COVID crash. But this cycle is different in so many ways - perhaps historical analogs will prove less useful.
Perhaps the biggest question, is what happens with QT. The Fed doesn’t talk much about its plans for balance sheet policy and I expect that the QT schedule will remain in place even with a pause in rate hikes3. If the Fed suspends or reduces QT, that would mark a significant and unexpected change that I would consider highly bullish.
In any case, enjoy the short-term yields - they may not be around too much longer.
Today marks the 50th installment of The Last Bear Standing. Thank you to all who have continued to read and engage with this column over the past year.
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Not everyone has much more money. Some people’s businesses were shuttered in the pandemic. Lower income segments have given back much of their “excess” savings already due to higher inflation. The largest beneficiaries were white collar workers who got to work-from-home, did not lose income, saved on expenditures, saw huge capital gains, and got various direct and indirect stimulus from the government. Generalizations fail to capture every situation, but on average people have much more money.
It is possible that seasonal adjustments have skewed the most recent data from March that make the drop in credit appear more severe. In March 2020, there was an enormous increase in bank credit due to companies drawing on credit facilities. This extreme case continues to skew seasonally adjusted data. Yet, the overall slowing in credit growth is a longer-term trend than just one reading.
Of course, this is ironic because QT is a key factor in banking stress, the subject of many prior posts.