Until Something Breaks

Interest rates and heartbreak

It is often said by clever people who manage to get invited on CNBC, Bloomberg, etc. that the Federal Reserve raises rates “until something breaks.” The Fed started its campaign on excess inflation in earnest in March 2022 when it began to ramp up the federal funds rate. Since that time, our nation’s policymakers have raised the upper limit on it from 0.25% to 5.5%.

And yet, nothing much has broken.

Oh sure, there was that mini-bank crisis involving Silicon Valley and Signature banks; those banks failed in part because of balance sheet losses related to interest rate-sensitive assets.

But the broader economy continues to expand despite geopolitical catastrophes and the lack of a House Speaker. We added 336,000 jobs in September. Unemployment remains pinned at less than 4%. Home prices have started rising again. Inflation has declined from more than 9% in June 2022 to less than 4% more recently.

Supported by an outrageously strong labor market, consumers are spending like there’s no tomorrow, including on Taylor Swift concert tickets (and she’s dating again). In other words, most of what we care about isn’t broken. While I expect her latest relationship to produce a breakup (based on history), it won’t be because of higher interest rates. It will probably be because it’s hard to catch passes while also staring up at corporate boxes.

And yet, the cliché regarding something breaking remains. Some economists have concluded that a soft landing is likely. Indeed, some indicate that the economy is bottoming out and ready to take off again.

I don’t see it that way. To be sure, I tend to be a pessimist (only natural as an Oriole’s fan). But I have other reasons than a lack of dating in college or being swept by the Rangers to be nervous.

Talk to a banker, and it becomes clear that there is reason for concern. Their cost of funds has risen massively. They are also concerned by rising delinquencies and exposure to declining office and other commercial real estate values. In other words, there is greater perception of risk, which also factors into their lending rates.

And then there are those regulators, who have shifted into high gear since March’s bank failures. That increases compliance costs. Some banks were recently debt downgraded, and I suspect more are to follow. All of this drives up the interest rates banks charge us, and I expect that to ultimately topple what has been a shockingly resilient economy.

Note that the Federal Reserve still has a significant distance to go before they meet their 2% economywide inflation target. As those pundits on cable news continue to point out, that means “higher interest rates for longer.” That is precisely correct.

And as Milton Friedman and Anna Schwartz taught us, monetary policy operates with “long and variable lags.” I continue to believe that much of the impact of higher interest rates is in front of us. A significant portion of the growth we have observed and the decline in inflation we have experienced since March 2022 is attributable to improved supply chains as opposed to rate increases, but those rate increases are about to bite and break some skin.

What’s Next

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