Fed crossroads due to financial crisis and inflation in the US

This week is likely to be very eventful globally, particularly with regard to what happens with the banking crisis in the United States which already had repercussions in Europe with the rescue of Credit Suisse by the Swiss National Bank and sale to the Swiss group UBS Group AG.

Before what happened with Credit Suisse, who minimized the potential for an escalation in financial tensions, pointed out that the business model of Signature Bank and Silvergate Bank was highly oriented to crypto assets, as well as Silicon Valley Bank to venture capital / tech startups.

This reasoning is very similar to the one that existed at the beginning of the “sub-prine” mortgage problem in the US in 2007. Many analysts of banks and international ratings agencies on Wall Street affirmed at that time that it was only a group of very particular banks and focused on this type of second-order mortgage loans.

The explanation was that a small group of financial institutions had theoretically given a second mortgage to individuals who were not qualified to receive them and who ultimately could not pay them. But this was not the case because the entire market was contaminated with financial derivatives leveraged by these types of mortgages and a kind of financial bubble had been created that finally burst.

It all ended in August 2008 with the bankruptcy of Lheman Brothers, one of the largest investment banks in the world, which later led to the aid from the fed to the financial system with large aid packages to prevent more large banks from failing and a sharp drop in short-term interest rates.

There are expectations about the decision that the FED will make regarding its monetary policy

The big question is what decision the US Federal Reserve (FED) will make regarding its future monetary policy at its meetings on March 21 and 22 regarding the short-term interest rate that is located in a range between 4.5% and 4.75% per year.

After the fall of three medium-sized regional banks in the US such as Silicon Valley Bank, Signature Bank and Silvergate Bank and the rescue of the Californian bank First Republic Bank by 11 American banks that injected some 30,000 million dollars into that entity on future of the United States economy was left at the center of the world scene.

What is the future of the US economy?

In relation to the future of the American economy, the latest report from the consulting firm Invecq highlights some key aspects of the US economy and its evolution in the face of the unexpected financial events of the last week, such as:

1) Economic activity is sustained in the US, with general growth of 2.7% per year in the last quarter of 2022, industrial production growing at 1.1% year-on-year and increased demand for capital goods.

2) The labor market remains solid, with an unemployment rate of 3.6% in February and historically low jobless claims (196,000 on average between the last half of February and the first half of March). In turn, there are still 1.77 jobs for every unemployed person: this is 2.7 times the average level of the last two decades.

3) The real estate market did suffer from the rise in rates that the Federal Reserve has been carrying out. The interest rate on 30-year mortgages has risen sharply from a record low of 3% in 2021, averaging 6.7% in March 2023. Construction of new private homes has also been affected, registering a 20% correction from highs.

4) In 2022 the economy showed year-on-year inflation of 6.44%, while in February it fell to 6%. However, this does not imply that inflation has really subsided in the US.

Although year-on-year inflation fell from the highs reached in June 2022 of 8.9% year-on-year, the truth is that since the beginning of 2023 annualized quarterly inflation has accelerated.

For this reason, Wall Street analysts are not sure what Fed Chairman Jerome Powell will decide after the next meeting this week.

In this regard, it should be noted that the soft vs. hard landing discussion was at a crossroads due to widespread fear of systemic contagion from the aforementioned banking events.

US inflation does not subside and suggests that the Fed will continue to increase rates

What was observed after recent financial events such as the closure of regional baths by withdrawal of deposits from savers it is that the financial market turned 180° with respect to what it expected after the statements of the president of the FED two weeks ago where he implied that the FED would continue with the policy of raising short-term interest rates.

This implies that the American and world financial markets stopped projecting rate hikes throughout 2023 and now expects that the Fed will not only stop raising them in 2023, but may also start lowering them this year.

In this regard, the economist Marcelo Elizondo, director of the DNI consultancy, explained to Iprofesional that: “in an economic world as disruptive as the one left by the pandemic, it is likely that the FED will prioritize lowering inflation and at the next meeting it will only go up 25 points the short-term rate and that it does not modify for now its monetary policy of raising rates that it has applied since 2022 and that it has maintained until now”.

While the Invecq study points out that the Fed is caught between:

a)maintain the course of its monetary policy to control inflation, which is far from its 2% target and with resilient levels of activity and employment

b) moderate the rise in rates and pivot to avoid a possible spread of systemic risk.

In this regard, the paper describes that: “for the moment we see a slowdown in the rate of rate rises and a clear discursive change in Powell and the members of the FOMC as more likely to occur, but not necessarily a 180° pivot soon when both inflation and the labor market continue to indicate to the Fed that macro risks remain latent.

As can be seen today, the fundamentals are not the same since before the Fed’s pivot was expected for fear of inflation and recession, while now doubts about a spread of systemic risk predominate.

The concrete thing is that today the US economy is facing greater financial astringency whose consequences are already being observed in the banking sector but which have not yet fully impacted the real economy, except in the real estate sector, which is already showing the impact.

US inflation does not subside

A large part of the inflationary acceleration The initial crisis suffered by the United States and the world in 2021 and most of 2022 was due to a sharp rise in the prices of energy commodities and problems of post-Covid supply restrictions that had a full impact on the price of goods.

However, US inflation has recently responded to the increase in prices for medical hotel and transportation services.

The good news for the Fed is that the external shocks that sharply accelerated inflation since mid-2021 appear to be fading.

While the bad news is that there are no excuses for service inflation. This CPI category, which is services, can be understood as a more genuine measure of the inflationary process, since services generally lack imported components and are not usually exposed to fluctuations in international prices, among other factors.

As can be seen, US inflation is not subsiding so easily, which could promptly lead one to think that the Fed will strictly continue with its stance of continuing to raise rates. However, this is not necessarily the case, as some Wall Street analysts believe that there is a high probability that the market could be on the verge of the end of the Fed rate hike, something that will finally be known this Wednesday when the Fed know your decision.