The United States is
entering a new economic era. I think we are in a
different environment than what we've experienced
over the past 15 years. It began with decisions by
the Federal Reserve. We've raised the federal
funds rate by 500 basis points since a little
more than a year ago. We also think that
there's more tightening power coming through. The speed of this hiking
cycle is distorting Wall Street and reshaping
personal finance in America. Why did the rate increases
come so fast? They came fast because in
a sense, the Fed got behind the ball. There are a number of
risks that emerge when interest rates rise
quickly. And so if you are a
person who borrowed money to buy equity, for
example, or even to buy a house, if you were not
careful, you could find the value of your assets
going down. Reversing zero interest
rates carries a pain with it that may not make the
initial zero. Interest rates have been
worth it. Like you take a drink and
it feels really good right now. But the hangover
tomorrow may mean that the drink you had the night
before wasn't worth it. Barring a catastrophe, I
don't think we'll see zero interest rates anytime
soon. So how is the US economy
adapting to higher interest rates? And have
we seen the full effect of the past decade's free
money policies at the Federal Reserve? Decisions made by the
Federal Reserve can influence the cost of
living in America. The Fed does that by
changing interest rates that can affect
inflation. Your job prospects and a whole lot
more. The Federal Reserve,
obviously being our nation's central bank,
has a primary tool to sort of shift gears on the
economy as needed. And that primary tool is
its benchmark interest rate. The Federal Reserve is
like a group of mechanics and the economy is their
machine. They can control the
speed at which the machine operates with a lever. In this analogy, the
lever represents interest rates. All gears in the
machine are influenced by the lever. Every so often
the mechanics at the Fed pull the lever to make
the machine spin slower or faster. Lower interest
rates and the economy speeds up. Raise interest rates and
the economy slows down. Interest rates today
stand above 5% as the Fed tries to slow the economy
down and fight inflation. The last couple of
inflation readings not only came in better, but
came in better than expected. And so that
suggests that the inflation fighting
medicine that the Fed has introduced to the economy
is having the intended effect. And that's good
for everybody because as Chairman Powell has said,
the economy really doesn't work for everybody or
anybody. If inflation is raging as
it. Has for an entire
generation. The United States
experienced very little inflation that gave
central bankers the ability to drop interest
rates to record lows. Doing that made jobs more
abundant a benefit for lower income workers. Running the economy a
little hotter might benefit. Groups that, you
know on the margin have a harder time trading up on
their jobs. We've seen gains from
that. And so some of these long
running differences we see across different
demographic groups in our economy like black white
wage differentials have declined as the economy
has been running hot for these last several years. So when interest rates are
low, you might have an easier time getting a
raise. At the same time, low interest rates may
make wealth inequality worse. When interest rates are
low, the economy, if it's not in crisis, is zooming
along. Fueled by low interest
rates, more and more people come into the
workforce, more jobs might be created, and there's
an increasing possibility that wage and income
inequality go down during periods of a hot economy. Wealth inequality, when
interest rates are low, tends to go up. That is because when
interest rates are low, other assets go up in
value. And so what we've seen
often is wealth inequality has increased. When interest rates are
low. In the United States,
central bankers have kept interest rates near zero
for the better part of 15 years. In that time, a
significant debate has rippled across the field
of economics. Is this so-called zero
interest rate policy good, bad or the best available
option? Having interest rates at
zero for such a long period of time is very
unusual. Frankly, no one thought
we'd ever get to that place. It's called the
Zero Lower Bound. In the past, major central
banks, including the Fed, took interest rates to
the effect of lower bound to fight deflation. Deflation is essentially
defined as a phenomenon whereby prices decline. That tends to delay
economic activity and leads to a slump in
economic activity. And that's why we
essentially had this environment where the Fed
was stimulating the economy. When money is cheap or
free, those that borrow money and then reinvest
it tend to do better because their cost of
borrowing is very low. And so private equity
firms, leveraged buyout firms, many real estate
investment trusts, investment ideas that are
built around leverage, built around borrowing
have a harder time when interest rates go up than
they do when interest rates are low. Suddenly
the amount that they have to pay back could go up. The economy grew steadily
through the 20 tens as more cash went into risky
investments, startups disrupted the
transportation, housing and tech industries. But some companies can't
handle today's higher interest rates. In the
first half of 2023, there have been 41 corporate
defaults in the US, the most of any region
globally. First of all, it's not
going to be quite as easy for everybody with a
stupid idea to get financing harder for
startups, it's harder to buy a home. So all of
those things create a higher hurdle rate. And the question becomes
not whether interest rates are zero versus not being
zero. The question is, are they
high or too high relative to the prevailing demand
for money out there? Banks and investors listen
closely to the mechanics of the Fed. Adjustments
to interest rates can change prospects for
whole industries like tech or real estate, which in
turn affects Wall Street and the banks. When interest rate is low,
mortgage rate tends to be low. People will have
more borrowing power. And they can borrow to
buy houses. The same principle applies
to commercial real estate. Many bets made in the low
interest rate era are no longer panning out. Mortgage is actually one
of the largest asset categories on banks
balance sheet. When interest rate
increases, the market value of those long term
assets will decline even if there is no default
risk. That is when the problem
comes in. You go to zero and you
encourage everybody to pile in, take on debt,
and it's probably fine this year, but next year
there's going to be a cascade of refinancings
that could really hurt the economy. And maybe there
are buildings that should not have been built,
purchases that should not have been made because
interest rates were so low at the time. We're talking a huge
amount of unrealized losses in the banking
sector. And on top of those
losses were realized that if there is going to be a
commercial real estate default, then the whole
banking sector is going to have trouble. But on the
right hand side of the balance sheet, you know,
we know that banks finance all of those long term
investments using short term deposits. Us banks hold deposits
from customers to balance out their loans, but
accounts at banks are only insured up to $250,000. Anything over this limit
could be lost in the event of a bank failure. Erica Jong and her team
believe that more US banks could collapse in the new
economic era. Svp was actually not very
special compared to other banks in the United
States, which showed that there are about 10% of
banks that experienced more asset value decline
than SVP. What made SVP special is
the insured deposits. And actually this insured
deposit ratio has been climbing in the past few
years and some people attribute that to low
interest rate. The Fed's interest rate
can change how much risk Wall Street is willing to
take on. Banks like to hold some
portion of their assets in a kind of more riskless
bucket, and we typically think of the government
bond portion as being a relatively lower risk. But bonds are designed to
be held to maturity. If a bank needs to sell
their longer term bonds to meet their reserve
requirements, they could end up being money
losers. Us banks have over $2.2 trillion in
unrealized losses that stem from the sudden
interest rate hikes. If any kind of stress
comes along and you're a bank and you have to
offload those bonds, that's where the problems
come. This sector, particularly
the smaller banks, regional banks, it's
going to be under earnings, duress,
earnings pressure for the foreseeable future. Rates
are high and potentially rising higher. That basically hurts
their underwater bonds on their balance sheet and
at the same time leads to deposit flight. For everyday people. In this new era, it can
pay more to save, especially when you park
your money in the right places. Our purchasing power is
eroding. And so we want to think
about savings vehicles that protect us from
that. And standard Bank accounts do a poor job of
that, and they're only going to be forced to pay
a higher interest rate if there's competition
coming from other parts of the financial system. We are at a time when it's
not that hard to find an interest bearing account
that pays three, four, 5%. And that's something we
haven't seen in many, many years, and that's
creating some wealth effects that we really
haven't seen for quite some time. The Federal Reserve's role
in society tends to expand in times of crisis. The first one was the
financial crisis of the late 2007 2008. That era. The FOMC reduced the
target federal funds rate from 5.25% in the summer
of 2007. To a range of 0 to 1
fourth percent by the end of 2008. The federal funds rate
has been at its effective lower bound ever since. And so it was trying to
prevent a really bad outcome like the Great
Depression. You know, when we go back to the Great
Depression, what did we see? We saw 9000 banks
failing. Ben Bernanke, he was a
student of the Great Depression. He didn't
want to repeat that. The effects of these
historic decisions and those made today will
stay with us for some time. We are currently
experiencing a central bankers vibe of higher
for longer. You're to some extent,
limiting nonproductive investments that would
not necessarily generate revenue in this high
interest rate environment. It's very different in a
low interest rate environment where money
is free and essentially any type of investment is
really worth it because the cost of capital is
close to zero. This new environment is
going to spur more business dynamism, more
of an entrepreneurial spirit, and also more of
that judicious thought process as to whether any
type of investment is really and truly worth
it. Economists believe that
those investments could become jobs, but that's
no guarantee in an age of automation. It's an interesting
question to me. For example, to look at
higher interest rates and the effect on artificial
intelligence. I talked to a lot of
investors about this and I said, what does 5% mean? And they're like 5%
interest rates by the Fed means nothing to me when
I'm looking to make 100, 200, 300, 400% on my
money, that 5% is irrelevant to them. However, if a guy is
saying, Where am I putting my money today versus
next year, then that 5% is very meaningful. Higher interest rates will
impact jobs to growth in the US. Labor market is
projected to jump by 8.3 million jobs in the
decade ending in 2031. That would mark a slower
decade of job market gains than Americans had in the
20 tens. The Fed wants to see the
economy slowing somewhat, but the risk of recession
also starts to go up. And there's quite a bit
of debate during this interest rate hike cycle
whether or not at the end of it there will be
what's called a soft landing. So that's one of
the big topics about this current rising interest
rate environment is where does it end? Does it end
with a soft landing or does it end with a
hopeless short and shallow recession? And no one
knows just yet.
