Will The Fed Continue Hiking Rates?

Vulnerabilities at banks in the US and Europe, but Inflation well above target.

The U.S. Federal Reserve is caught between a rock and a hard place.

This week has seen vulnerabilities at Silicon Valley Bank, Credit Suisse and Republic Bank of California. But inflation is still well above target rates.

The FOMC (Federal Open Market Committee) will meet on 22nd March to consider another rate hike so what should we expect?

I break it all down in a short 5 minute read.

A Summary of the Situation

1. ZIRP (Zero Interest Rate Policy) went on for way too long following the 2008 crisis. The economy became intoxicated on cheap money and asset price bubbles appeared everywhere (for example real estate, tech stocks, crypto currencies).

2. Quantitative Easing (QE) resulted in the Fed balance sheet ballooning to $9 trillion at its peak as it bought assets in return for injecting cash into the economy. Cheap money was raining from the sky. It resulted in one hell of a party that went on for a decade and a half, but it was all fueled by debt.

3. The collapse of Lehman Brothers, a systemically important bank back then, led to market contagion and regulators introduced new rules to prevent this kind of thing ever reoccurring. Capital adequacy requirements compelled banks to hold "risk free" (a misnomer) long term debt instruments which were acquired at peak prices due to ZIRP (fixed income product prices are inversely correlated to rates).

4. Inflation bites following a combination of the Russian invasion of Ukraine and supply chain constraints from the Covid19 pandemic. After 15 years the Fed finally abandons ZIRP and interest rates normalize.

5. Quantitative Tightening (QT), the opposite of QE, reduces the size of the Fed's balance sheet. $100bn of bonds are allowed to mature each month and not rolled over.

6. The yield curve inverts (rates are higher in the short end of the yield curve) which is usually a precursor to a recession. Fixed income products collapse as the market chases higher yields both to compensate for the increased market risk and the destructive nature of inflation on the value of a dollar. This is exacerbated by the rising rate environment augmented with the QT program.

7. Balance sheets of commercial banks become impaired (it is ironic that measures introduced to sure up the banking sector caused the vulnerability). Because of regulatory pressure, banks were forced to load up on bonds at the worst possible time.

8. The Federal Reserve wants to hike rates to counter inflation, but is concerned about more stress on banks as their assets devalue. So it announces a tactical solution in the form of Bank Term Funding Program (BTFP) which will enable banks to use fixed income products as collateral to raise cash from the central bank. Of critical importance is that bonds now held by banks, that have lost substantial value as described above, will go to the central bank at face value. This facility provides a permanent backstop for the banking system, allowing banks to borrow funds from the Fed on an ongoing basis, instead of relying on short-term funding markets.

9. Short term the problem is fixed. But BTFP works counter to the objective of the QT program as it slows the drawdown of the Feds balance sheet. It may also lead to potential inflationary pressures in the long term. But it does enable the Fed to continue hiking rates without fear of systemic stress to the banking sector.

Conclusion

The BTFP will enable the Fed to continue hiking rates without fear of bank collapses. Its fight against inflation remains its primary mandate.

Expect a hike at the Fed's meeting on 22nd March next week and more in the months to come.

The side effects of ZIRP and QE are now showing. It was a mistake to continue with these policies for an extended period as happened over the last decade and a half.

We should not expect central banks to repeat that mistake. Expecting rates to be cut and a new round of QE to commence in the next year or two, as some do, is foolish.