The authors are the CEO of the financial consulting firm Complex and an analyst at the company. The parties in the article may invest in securities and / or instruments, including those mentioned in it.
The most important question today in the financial markets is whether the US Federal Reserve (Federal Reserve, or the Fed) will be able to curb the highest inflation in the last 40 years, without putting the US economy into recession.
In theory, this involves raising the interest rate to the “right” extent, to the “neutral interest rate”, which does not restrict and does not stimulate economic growth. That is, interest rates are high enough to curb inflation, but not too high so that the economy will continue to grow.
In practice, the task is particularly complex due to the multiplicity of influencing variables and the need for subjective assessments. It is very difficult to reach a consensus on the neutral interest rate.
To illustrate the challenge, from a historical perspective, in 6 out of 8 attempts to curb inflation while raising interest rates since the 1970s, there has been a US recession.
The Fed lags behind inflation
The starting point today for climbing the neutral interest rate is particularly complex. The Fed interest rate is in the range of only 0.5% -0.25%, against inflation of 8.5%, and reflects a deep negative real interest rate of minus 8%.
This is because the Fed was significantly late. In 2021, the central bank assumed that inflation would be transient, but rising price pressures in a variety of sectors, and Russia’s invasion of Ukraine, exacerbated the situation.
In addition, the low interest rates today are not suitable for the boiling labor market. In March, about 430,000 jobs were added in the United States and the unemployment rate fell to 3.6%, a situation that reflects full employment and strong incentives for wage increases, which will continue to fuel inflation.
In our view, the Fed still enjoys public confidence that inflation is temporary. However, its persistence creates a risk for the development of an “economy of expectations”, in which the various players estimate that inflation will continue to rise and adjust prices accordingly on an ongoing and predictable basis. For example, in the case of long-term contracts such as real estate rent and employee wages. The sharp rises in residential real estate prices, which crossed 20% in annual terms, along with an average annual wage increase of 5.6%, are worrying processes that need to be curbed quickly.
Different interest rates for different time periods
The various estimates by the Fed regarding the desired rate of the neutral interest rate range from 2% to 3%, with a median of 2.4%. However, these estimates are appropriate for routine days when inflation meets the Fed’s 2% target, which is far from the case today.
In practice, the neutral interest rate varies significantly between different time horizons, depending on the state of the economy and inflation at any given time.
In our view, the neutral interest rate required for the US economy in the short run is much higher than the long run.
Therefore, in our opinion, the Fed will make at least two exceptional interest rate hikes of 0.5% (as opposed to the usual 0.25% hike) in the coming months, starting in May. In order to illustrate how unusual this is, we will mention that no interest rate hike has been made at such a rate for more than two decades.
As a result, in our estimation, the Fed’s forecasts that the interest rate will rise to 1.9% by the end of next year, and 2.8% by the end of 2023, significantly underestimate the need to raise interest rates. Evidence is that markets are pricing interest rates in the range of 2.75% -2.5% in early 2023. We are going one step further and estimate that interest rates will rise to 3% and above by the end of 2022 and towards 4% during 2023, as long as inflation remains above the Fed’s target range.
On the other hand, in the coming years, assuming that inflation restrains, interest rates may fall back to a range of 2% -3%, reflecting a long-term neutral interest rate.
In our view, the sharp and temporary rise in interest rates in the coming years to tackle inflation is the best explanation for the recent reversal of the yield curve, which has led to announcements – too rapid in our view – of an impending recession.
Another complexity: reducing the balance sheet
Another complexity stems from the planned reduction in the Fed’s balance sheet, which stands at about $ 8.9 trillion, double its size before the corona crisis. The Fed’s balance sheet consists mainly of government bonds and mortgage-backed bonds.
The balance sheet reduction is expected to begin in parallel with interest rate hikes, as early as May, at a rate of $ 95 billion a month, or more than $ 1 trillion a year. This is done by not reinvesting the receipts of bonds that come to maturity and not through the direct sale of bonds to the markets, an option that is currently maintained in the Fed stack as a tool for a sharper tightening of financing conditions.
To illustrate the strength of the combined move, in 2015 the Fed made the first rate hike after the financial crisis, but waited another two years until it began reducing its balance sheet, at just $ 50 billion a month, half the rate currently planned.
The reduction in the balance sheet is expected to lead to a cross-cutting effect on the rise in government bond yields and mortgage interest rates, along with the parallel rise in interest rates. The U.S. government will rise to 2.8% today, compared to less than 1.5% in early 2022, and the 30-year mortgage rate to 5%, compared to 3% at the beginning of the year.
The extent of the impact in the future depends on the response of the bond markets to the actual moves, which is particularly difficult to predict in light of the one-off reversal of a particularly easing monetary policy for a decade and a half. End of 2022.
Such a significant increase in risk-free interest rates is expected to create dramatic effects on liquidity conditions and the risk-chance equation in the markets. The victims are expected to be headed by many non-profit technology companies, which have benefited from “cheap” cash flow, various cryptocurrencies that will suffer value return and return to “real money”, shares of leveraged companies that will decide under the burden of exorbitant financing costs and debt roll-over challenges. Long-term, which will absorb capital losses along with an increase in failure rates.
Facing the challenges, the key point is the Fed’s ability to raise interest rates and reduce its balance sheet, without succumbing to short-term market declines, as has happened in the past. Success in the mission will support the performance of markets and the economy in the longer term, while failure to produce a sustained and dangerous inflation environment.