In their campaign to tame rising prices, the Federal Reserve has raised interest rates by a total of 4.75 percent over the most recent nine consecutive meetings. The Fed’s primary focus, referred to as the “dual mandate,” is on inflation and employment.  A year into this battle, inflation remains stubbornly high, while tighter monetary policy has impacted important sectors of our economy.  Banks are showing the strain of rising interest rates, but that is just the latest collateral damage in a campaign to regain price stability.  So far, overall employment has held up remarkably well, although businesses are planning for a period of economic sluggishness in the months ahead.  The challenge is for the Fed to curb inflation quickly, because more collateral damage will likely accumulate the longer this battle goes on. 

Attractive borrowing rates created a boom in mortgage refinancing in 2021.  As rates more than doubled in the past year, mortgage activity stalled.  Loans made at low rates have become less valuable to the banks that own them.  Banks borrowed from depositors in order to make those loans, and depositors are still owed the full amount of funds placed at their bank.  Declining asset values of loans and bonds, combined with fixed liabilities (deposits), put strain on the balance sheet for banks.  That may be tolerable during a period of stability.  However, if an unexpected number of depositors ask for their money (a “run” on the bank), the bank is forced to sell their assets at a loss.  The Federal Deposit Insurance Company (FDIC) was created in 1933 to protect customer deposits in the event of a bank failure, and no depositor has since lost a penny of FDIC-insured funds.  The limit on insured funds currently stands at $250,000 per depositor, a figure that was raised from $100,000 in 2010 after the Credit Crisis.  Technically, the FDIC is not required to backstop deposits over that amount.  However, they did choose to fully back all deposits, even the uninsured balances, in the latest round of bank failures.  It is an open issue as to whether that sets a new precedent by which deposits of any amount are effectively protected by the U.S. government.  Until that topic is clarified, we encourage clients to limit their deposits to the $250,000 limit at any single bank.  Deposits with a bank are different than investment accounts held at a brokerage firm, where those assets are held separate from the company’s balance sheet.

In the most recent meeting of the Federal Open Market Committee (FOMC), they did take into account the stress being placed on our banking system when choosing to make another rate hike.  The Fed’s dual-mandate is inflation and employment.  Other areas of our economy may be struggling, but they are not the Fed’s primary concern.  Housing and banking are clearly feeling the impact of higher interest rates, yet hiring has remained strong.  The official unemployment rate is a mere 3.6 percent, and recent data continue to show net new job creation.  Inflation peaked last summer around nine percent, and it has since cooled a bit to around six percent.  That remains well above the Fed’s target of two percent inflation.  Aggressive tightening of monetary policy is intended to slow our economy, possibly tipping us into recession.  The Fed signaled that they are nearly done raising rates, with perhaps one more small rate hike coming at the May or June FOMC meeting.  At that point, they will pause to see how the economy responds.

Attention is shifting from the Fed to the impact of higher rates on our economy, with analysts estimating the depth and duration of a likely downturn in activity.  As a result, the Fed may be raising their target rate, but capital markets are actually lowering interest rates across the maturity spectrum.  The yield on 10-Year Treasury securities has slipped to 3.55 percent from its 3/2/23 high of 4.08 percent.  For Two-Year Treasuries, the yield is now 4.10 percent after peaking on 3/8/23 at 5.05 percent.  Rates are coming down because the Fed’s tighter monetary policy will likely succeed at slowing the economy.  It is quite possible that we have reached the inflection point and have already seen the peak in market-based interest rates.  

Consumers appear to be stretched thin.  According to the Federal Reserve Bank of New York, total household debt has reached a new record, at $16.90 trillion.  Most of that is mortgages ($11.92 trillion), auto loans ($1.55 trillion) and student loans ($1.60 trillion).  However, credit card debt has shot up to $986 billion, a figure that increased 15.2 percent from the prior year.  That is the highest growth rate on record, with data going back to 1999.  The average interest rate on credit card debt is a whopping 21.60 percent, revealing the toxic nature of rising credit card balances on the average household.  

Investors endured a difficult year in 2022.  It is likely that we are working our way past the inflection point in Fed policy and interest rates, and are heading into a period of sluggishness for the economy.  Housing felt the impact right away, as rapidly rising rates stalled transaction volume and led to seven consecutive months of price declines in home values.  Now, the banking sector is showing signs of pressure, and consumers are digging deeper into their wallets to maintain their standard of living.  This is the moment of truth for the Fed.  Their actions need to achieve the desired result of lowering inflation before too much collateral damage accumulates.  With inflation out of the way, monetary policy can return to normal and the economy can look forward to growth.  That would be good news for investors.

We hope the heavy winter weather has not been problematic and will lead to a beautiful spring season for you and your family.  Please contact us if you have any questions.