On Wednesday, March 22, the Federal Open Market Committee of the U.S. Federal Reserve held its second meeting in 2023. At the first meeting, the central bank boosted the short-term Fed Funds Rate by 25 basis points, pushing it to 4.50% to 4.75%. Between early February and the late March meeting, the markets began to experience some of the fallout of tight monetary policies. Rate hikes in 2022 and early 2023 and quantitative tightening at $95 billion monthly played a role in two U.S. bank failures. UBS had to take over Credit Suisse on the global landscape as the bank faced liquidity issues.
At the March 22 meeting, the Fed had two choices: continue to battle the highest inflation in four decades or pause to allow the previous rate hikes to filter through the economy. The latest inflation data favored at least another 25-basis point increase, while the bank turmoil was a reason for a pause.
The Fed tried to walk in the middle of the road
The FOMC increased the Fed Funds Rate by 25 basis points, pushing the rate to between 4.75% and 5.00%. The statement said that “additional firming may be necessary,” changing the previous message from “additional rate hikes are appropriate.”
The Fed went on to say that recent developments (the bank sector failures) should tighten credit and left the forecast for the end of 2023 at 5.13%. Therefore, the central bank projects that one more 25-basis point should suffice. While inflation remains “elevated,” the U.S. banking system remains sound. Chairman Powell reiterated his view of the banking system at the beginning of his monthly press conference.
The Fed tried to balance a hawkish message to push inflation to the 2% target rate. However, in testimony on Capitol Hill, Treasury Secretary Yellen poured cold water on the Fed’s careful message by answering questions on uninsured banking deposits with obtuse answers, causing stocks to fall. After the Fed’s rate hike and message, gold futures rallied to over the $1,970 level
The damage is already done
Recent bank failures and UBS’s takeover of Credit Suisse are fallout from the trajectory of interest rate hikes to stem the highest inflation since the 1980s. Banks that invested customer on-demand deposits in government debt securities ran into trouble when waves of depositors withdrew their money. While government debt securities are safe when held to maturity, rising rates caused the mark-to-market value to drop over the past year, causing losses. Since the value of the bonds fell below the on-demand deposits, banks that did not manage interest rate risks failed.
Poor management and regulators asleep at the wheel caused the bankruptcies. With over $200 billion in assets, Silicon Valley Bank was the second-most significant failure in history, behind the 2008 Washington Mutual bankruptcy.
SBV, Signature Bank, and Credit Suisse were the first victims of the central bank’s hawkish monetary policy, committed to pushing inflation lower. During his press conference, Chairman Powell said banks would likely tighten credit, putting more downside pressure on inflation and economic growth.
Inflation may not come down- StagflationThe Fed is counting on tight credit to stamp out inflation and send it to the 2% arbitrary target level. Meanwhile, monetary policy impacts the economy’s demand side, and the trajectory of interest rates will likely push the economy into a recession. However, there are no guarantees that inflation will come down. The war in Ukraine and the bifurcation of the world’s nuclear powers have caused trade distortions via sanctions and Russia’s use of food and energy commodity exports as economic weapons.
The Fed waited far too long to tighten credit and now may be choking the economy with the trajectory of rate hikes over the past year that went from zero to five percent from March 2022 to March 2023. Stagflation is elevated inflation when a recession grips the economy. As I wrote in a March 14, 2023, Barchart article, “The Fed is committed (to fighting inflation), but the record is dubious.”
Watch commodity prices- Geopolitics is critical
Russia and Ukraine are significant agricultural exporting countries, and Russia is the most influential non-OPEC member, with production policy a function of decisions in Riyadh, Saudi Arabia, and Moscow.
While crude oil futures have dropped from over $130 per barrel last March to around $70 level, and agricultural commodities have moved lower, the odds are that these markets will reach higher lows and resume their upward trends. Crude oil is moving into the driving season, and agricultural products are now in the planting season in North America. While the weather is always the most significant factor for the path of least resistance of grain and oilseed prices, farmers will need to compensate for losses in Europe’s breadbasket in Ukraine and Russia. Russia is a leading fertilizer exporter, which has caused supply shortages and high prices, increasing global production costs. Moreover, as the Chinese economy emerges from its COVID-19 lockdowns and China’s alliance with Russia means that commodity flows from Russia will likely head to China and other “friendly” countries, punishing those nations supporting Ukraine.
Commodities are worldwide essentials, and prices will determine inflation over the coming months.
The well-intentioned Fed may fail in its inflation battle as supply-side issues transcend monetary policy actions.
The U.S. debt ceiling is crucial for faith and credit
The slim Republican majority in the U.S. House of Representatives and the Biden administration have different spending goals. The U.S. must address its current debt ceiling, with the national debt at over $31.6 trillion and rising. Short-term rates at 5% increase the deficit by $1.58 trillion without additional spending.
Failure to raise the debt ceiling would cause the U.S. to default, shaking investors’ confidence in U.S. debt securities and the U.S. dollar. A U.S. debt default would be a financial disaster that ripples across the global economy.
The dollar and U.S. government bonds’ value depend on the full faith and credit in the U.S. government. In late March 2023, the divided government could be the most significant threat to the financial system. The administration has said it will not negotiate to raise the debt ceiling, while the House has said it will not agree without some compromise.
The bottom line is the Fed is continuing to fight inflation, but supply-side issues caused by the war and Washington’s relations with Beijing/Moscow and the debt ceiling could be the problems that cause the next crisis. Investors and traders should pay careful attention over the coming weeks and months. The bank failures came from not hedging risks, and the current environment requires prudent risk management for all investment and trading portfolios.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
