More than two years have passed since the Federal Reserve’s most aggressive monetary tightening in four decades. The big surprise was that the world did not collapse.
While U.S. interest rates at a 23-year high are painful, there is nothing like the systemic problems that have so often hampered economic growth in the past. The Fed has held the rate at 5.25% to 5.5% for about a year and is expected to leave it unchanged at its two-day policy meeting this week.
As Friday ended a streak of solid economic data, investors have once again abandoned their rate cut expectations, with only one or possibly two rate cuts now expected by the end of the year.
Financial markets continue to digest very well what Chairman Jerome Powell calls “restrictive” policies. The three U.S. regional bank failures in the spring of 2023 are most notable for how little impact they had on the economy and how quickly regulators were able to stop any contagion. Credit spreads remain tight even among riskier bonds, and volatility is low.
In other words, something different is happening this time, and it’s getting the attention of the Federal Open Market Committee (the Fed committee that sets interest rates), and they’ll likely bring up the topic of easy financial conditions again this week. Here are three unusual features that help explain why the policy may be less relevant:
Privatization of risk
When technology stocks began to fall in 2000 and subprime mortgage assets fell in 2007, everyone could see it. As fears of losses spread, the sell-offs affected more and more assets, causing wider contagion and ultimately crippling the economy.
What is different today is that an increasing share of funding comes from private rather than public markets. This is partly due to increased regulation of public financial institutions. Pension funds, endowments, family offices, ultra-wealthy individuals and others are now more directly involved in lending through non-bank institutions than in the past.
Non-bank lenders work particularly heavily with mid-sized firms, but they also work with large corporations. An estimate of $1.7 trillion in private credit is often cited, but a lack of transparency means there are no accurate official figures.
Because this lending is out of sight of public markets, problems that arise are less likely to cause a chain reaction. Missed interest payments do not make public news headlines, leading investors into herd behavior.
Pension funds and insurance companies that invest in private credit funds are unlikely to ask for their money back tomorrow, reducing the risk of their funding suddenly drying up.
Warning:
Just because nothing in this area has caused a major explosion doesn’t mean it won’t happen. The recent incident in which the company moved assets out of reach of its creditors (as part of an attempt to raise new financing) was an eye-opener for many on Wall Street.
The IMF devoted an entire chapter to private lending in its April financial stability report, and its assessment was mixed. The size and growth of the market means “it could become macrocritical and amplify negative shocks,” the fund said. Pressure to close deals could lead to a “lower underwriting standard.”
Fabio Natalucci, deputy director of the fund who is overseeing the report, said in an interview that right now “the private lending ecosystem is opaque and there are cross-border implications” if the market convulses.
He is concerned about the “levels of leverage” in the chain of investors, funds and the companies they own.
Government debt drives growth
The 1990s expansion ended in failure after companies overextended themselves, intoxicated by dreams of dot-com riches. In the 2000s, it was households who used debt, borrowing against expected increases in their net worth. This time, the federal balance sheet played an unusually large role in the expansion.
Government spending and investment made the highest contribution to GDP growth in 2023 in more than a decade, and of course it was financed by debt, which amounted to 99% of GDP in fiscal year 2024, according to the Congressional Budget Office.
The chart below shows how dramatic the role reversal has been between households and government:
Government debt is called a risk-free asset because it is safer than a household or company because the federal government has the power to levy taxes. This means that using the federal balance sheet to drive economic growth is inherently less dangerous than a surge in private sector borrowing.
Warning:
Even governments can get into trouble, as the UK found out in 2022 when investors abandoned plans for large, unfunded tax cuts. Rising interest rates are increasing US borrowing requirements, and there are warnings that the US is on an unsustainable fiscal path.
“There is almost certainly a limit to how much debt can be outstanding without the market pushing yields,” said Seth Carpenter, chief global economist at Morgan Stanley. Still, “if there is a tipping point, it’s hard to believe we’re at it right now.”
Fed balances risks
While the Fed has raised interest rates and trimmed its bond portfolio, Powell and his colleagues have been especially alert to downside risks. The central bank launched emergency funding when the Silicon Valley bank collapsed in March 2023, even as it battled inflation.
Powell and his aides have also effectively abandoned further rate hikes in the face of a still-strong economy and an inflation rate that remains above policymakers’ target. There is even a stated inclination to cut borrowing costs as a sign that we are trying not to act too late and send the economy into recession.
The Fed’s communications help limit volatility and help ease financial conditions overall. This appears strategic and deliberate on the Fed’s part, suggesting that Powell and his team are primed for the powerful threat of a so-called financial accelerator, where rising unemployment or falling incomes feed back into markets and amplify negative shocks, risking a rapid economic meltdown. slipping into recession.
The Fed is trying to keep its “tight” monetary policy several notches below the boiling point. This created a paradox. Fed officials say their policies are restrictive but financial conditions remain easy.
Warning:
Fed policymakers cannot micromanage every aspect of the financial system and economy. There are real pockets of pain, and the risks are concentrated in less noticeable places. High interest rates over a long period are really starting to bite.
“There’s a lot more stress behind the scenes,” said Jason Callan, head of structured asset investing at Columbia Threadneedle Investments. “The real linchpin is the labor market.”
Most lending to low-income households is carried out by fintech companies outside the control of regulators. The resilience of the shadow banking system and consumers in a downturn without paycheck protections and stimulus checks remains to be seen.
“The more inequality, the more financial instability,” Karen Petrou, co-founder of financial sector analysis firm Federal Financial Analytics, said in a recent speech. “It is increasingly likely that even mild stress to the macroeconomic or financial system can quickly become toxic.”