(Bloomberg) — More than two years after the Federal Reserve’s most aggressive monetary tightening in four decades, the big surprise is that the world hasn’t fallen.
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While US interest rates at 23-year highs are causing pain, there’s nothing like the systemic problems that so often derailed expansions in the past. The Fed has kept its policy rate at 5.25% to 5.5% for about a year and is expected to leave it unchanged at its two-day policy meeting this week.
With Friday capping a string of solid economic data, investors have scaled back their expectations for rate cuts, with just one or perhaps two now expected by the end of the year.
Financial markets continue to digest what Chairman Jerome Powell calls restrictive policy very well. The three US regional bank failures of spring 2023 are most notable for how little they affected the economy and how quickly regulators were able to stop any contagion. Credit spreads remain tight, even among riskier bonds, and volatility is low.
In other words, something different is happening this time, and it’s getting the attention of the Federal Open Market Committee, the Fed’s panel that sets interest rates, and they’re likely to take up the subject of easy financial conditions again this week. week. Here’s a look at a trio of unusual features that help explain why the policy may have less bite:
Privatization of risk
When tech stocks started to fall in 2000 and subprime mortgage-related assets fell in 2007, it was obvious for all to see. As the fear of losses spread, fire sales affected more and more assets, causing a wider contagion that eventually engulfed the economy.
What is different today is that an increasing share of funding has come from private rather than public markets. Part of this is due to stricter regulation of publicly listed financial institutions. Pension funds, endowments, family offices, ultra-wealthy individuals and others are now more involved in lending through non-bank institutions than in the past.
Non-bank lenders have been particularly active with medium-sized firms, but they are also involved with large corporations. There is an oft-cited estimate of private credit as high as $1.7 trillion, but a lack of transparency means there is no exact official number.
Because this lending is outside the visibility of public markets, problems that develop are less likely to cause contagion. Missed interest payments are not the subject of public news headlines, stunning investors into herd-like behavior.
Pension funds and insurance companies that invest in private credit funds are unlikely to demand their money back tomorrow, reducing the risk of a sudden funding freeze.
Warning:
Just because nothing in this field has produced a big hit yet doesn’t mean it won’t. A recent incident where a company moved assets beyond the reach of its lenders as part of a move to raise new financing was an eye-opener for many on Wall Street.
The IMF devoted an entire chapter to private credit in its April financial stability report, and their assessment was mixed. The size and growth of the markets means it can become macro-critical and amplify downside shocks, the fund said. The pressure to make deals can lead to lower underwriting standards.
Fabio Natalucci, a deputy director at the fund overseeing the report, said in an interview that the private credit ecosystem is murky and that there are now cross-border implications if the market goes through a convulsion.
He worries about the layers of leverage in the chain of investors, the funds and the companies they own.
Government debt powers growth
The 1990s boom ended in a crash as companies overextended themselves, filled with dreams of dot-com riches. In the 2000s, it was households who used their leverage, borrowing against expected gains in home equity. This time, it is the federal balance sheet that has played an extremely large role in the expansion.
According to the Congressional Budget Office, government spending and investment contributed their highest share of GDP growth in 2023 in more than a decade, and of course it was financed with debt, which stood at 99% of GDP— in fiscal year 2024.
The chart below shows how dramatic the role change has been between families and the government:
Government debt is referred to as a risk-free asset because it is safer than a household or company since the federal authorities have the power to tax. This means that increasing the federal balance sheet for growth is inherently less risky than an increase in private sector borrowing.
Warning:
Even governments can get into trouble, as the UK found in 2022 when investors rejected plans for huge unfunded tax cuts. Rising interest rates are swelling US borrowing requirements and warnings are emerging that the US is on an unsustainable fiscal path.
There is almost certainly a limit to how much outstanding debt there can be without the market driving up yields, said Seth Carpenter, chief global economist at Morgan Stanley. However, if there is a tipping point, it’s hard to believe we’re at it now.
The Fed is balancing risks
As the Fed has been raising interest rates and shrinking its bond portfolio, Powell and his colleagues have been particularly attentive to downside risks. The central bank stepped in with emergency funds when Silicon Valley Bank collapsed in March 2023, even as it struggled with inflation.
Powell and his lieutenants have also effectively ruled out further rate hikes in the face of a still-strong economy and an inflation rate that remains above policymakers’ target. There is also a stated bias to lower borrowing costs, in a move to try to avoid acting too late and tipping the economy into recession.
Communication with the Fed is helping to limit volatility and contributing to an easing of financial conditions in general. It appears strategic and deliberate on the part of the Fed, suggesting Powell and his team are attuned to the powerful threat of a so-called financial accelerator, where a rise in unemployment or a drop in incomes reverberates through markets and amplifies shocks. negative, risking a quick blow. the descent into recession.
The Fed is trying to keep its tight monetary policy a few notches below the boil. This has caused a paradox. Fed officials say their policy is tight, but financial conditions are still easy.
Warning:
Fed policymakers cannot micromanage all aspects of the financial system and the economy. There are real pockets of pain and risks are concentrated in less visible areas. Therefore, the high interest rates for a long period begin to fall.
Behind the scenes, there’s a lot more stress, said Jason Callan, head of structured asset investing at Columbia Threadneedle Investments. The real bottom line is the job market.
Much of the lending to low-income households is done by fintech firms beyond the oversight of regulators. The resilience of the shadow banking system and consumers to a downturn without wage protections and stimulus controls remains to be seen.
The more inequality, the more financial instability, Karen Petrou, co-founder of Federal Financial Analytics, a financial sector analysis firm, said in a recent speech. It is increasingly likely that even small amounts of macroeconomic or financial system stress can quickly turn toxic.
–With assistance from Laura Curtis.
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