The Federal Reserve has been trying for more than a year to convince investors, consumers and businesses that it is serious about slowing the economy and taming inflation with higher interest rates. But it has not worked, so far. Consumers have kept shopping. According to the Bureau of Economic Analysis, in January consumer spending saw its sharpest rise in nearly 2 years. And businesses have kept hiring. They added more than 300,000 new jobs in February alone, and the unemployment rate remains at very low levels. Investors still buy stocks. While the market has its ups and downs in recent months it seems that it has formed a bottom in mid-October of last year and has gradually risen more than 10% since then.
The Fed seems desperate. The Fed’s instrument of raising short-term interest rates just is not enough to cool the economy down. The Fed did also not realise that something was boiling in bank balance sheets that just might accomplish the central bank’s goal of slowing the economy.
The global financial crisis of 2007-2008 was caused by banks with too many toxic assets (like subprime mortgage loans and derivative assets linked to them such as credit default swaps) on their balance sheet. The problem this time is serious interest rate risk. When interest rates rise, the value of long-dated assets falls. Of course, if you hold these bonds to maturity, you’re going to get your money back. But depositors at these regional banks wanted their money now, not in 10 years. That’s called an asset-liability mismatch. It caused the runs on those banks and got them into liquidity problems and finally drove them under. And nobody at the Fed or anywhere else seemed to see this coming.
The consequences of those bank failures may have just the impact on the economy and the market that the Fed was seeking all along. When financial conditions like risk-taking and credit availability worsen, the economy cools. And now, suddenly they’re worsening rapidly. This is what the Fed wanted all along even if it had nothing to do with their strategy.
Sven Franssen