More than two years after the Federal Reserve embarked on its most aggressive monetary tightening in four decades, the amazing thing is that the world is not falling apart.
While U.S. interest rates are at 23-year highs, causing some pain, nothing outweighs the systemic problems that have often derailed economic expansion in the past. The Federal Reserve has kept its policy rate at 5.25% to 5.5% for about a year and is expected to keep rates unchanged at its two-day policy meeting this week.
Following a slew of solid economic data on Friday, investors once again lowered their expectations for rate cuts, with just one or two rate cuts now expected by the end of the year.
Financial markets continue to price in well what Chairman Jerome Powell has called “restrictive” policies. The three regional U.S. bank failures that occurred in the spring of 2023 were the most notable because they had minimal economic impact and regulators were able to quickly stem any contagion. Even among riskier bonds, credit spreads remain smaller and volatility is lower.
In other words, something different is happening this time, and it has caught the attention of the Federal Open Market Committee (the Fed’s rate-setting panel), who are likely to discuss the topic of loose financial conditions again this week. Here are three unusual characteristics that help explain why the policy may have less impact:
Risk privatization
Technology stocks began to fall in 2000, and subprime mortgage-related assets plummeted in 2007. This is obvious to all. As fears of losses spread, fire sales affect more and more assets, causing wider contagion and ultimately pummeling the economy.
The difference today is that more and more financing is coming from private markets rather than public markets. This is partly due to tighter regulation of listed financial institutions. Retirement funds, endowments, family offices, the ultra-rich and others are now more directly involved in lending through non-bank institutions than in the past.
Non-bank lenders are particularly active with mid-sized businesses, but they also work with larger businesses. Estimates of total private credit of $1.7 trillion are often cited, but a lack of transparency means there are no accurate official statistics.
Because such loans are not visible on the public market, if something goes wrong, it is unlikely to cause contagion. Missed interest payments are not the subject of public news headlines and can lead investors into herd behavior.
Pension funds and insurance companies that invest in private credit funds are less likely to demand their money back tomorrow, reducing the risk of a sudden stoppage of funding.
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Just because there haven’t been any major explosions in the area doesn’t mean it won’t happen. In a recent incident that opened the eyes of many on Wall Street, a company moved assets out of the control of its lenders — as part of a move to raise new financing.
The International Monetary Fund devoted a chapter to private credit in its April Financial Stability Report, and their assessment was mixed. The fund said the market’s size and growth meant “it could have a significant macroeconomic impact and amplify negative shocks”. The pressure to do a deal can lead to “lowering of underwriting standards.”
Fabio Natalucci, the fund’s deputy director overseeing reporting, said in an interview that the private credit “ecosystem is opaque and has cross-border implications” if markets experience turmoil.
He worries about “leverage” in the chain of investors, funds and companies they own.
Government debt fuels growth
The expansion of the 1990s ended in collapse as companies overextended themselves and became obsessed with dreams of getting rich online. In the 2000s, households leveraged themselves, borrowing against expected returns on their home equity. This time, the federal balance sheet plays an unusually large role in the economic expansion.
In 2023, the contribution of government spending and investment to GDP growth reached its highest level in more than a decade, and of course it was financed through debt – 99% of GDP in fiscal 2024, according to the Congressional Budget Office .
The chart below shows how dramatic the role reversal between families and government has been:
Government debt is called a risk-free asset because it is safer than households or companies because federal authorities have the power to tax. That means using the federal balance sheet to fuel growth is inherently less dangerous than a surge in private sector borrowing.
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Even governments can get into trouble, as the UK found out in 2022, when investors balked at a massive, unfunded tax cut package. Rising interest rates are driving up U.S. borrowing needs and there are growing warnings that the U.S. is on an unsustainable fiscal path.
“In the absence of markets pushing yields higher, the amount of debt outstanding will almost certainly be limited,” said Seth Carpenter, chief global economist at Morgan Stanley. Still, “if there is a tipping point, It’s hard to believe we are at this turning point.”
The Fed is balancing risks
Even as the Fed raises interest rates and shrinks its bond portfolio, Powell and his colleagues are particularly wary of downside risks. When Silicon Valley Bank collapsed in March 2023, the central bank rushed emergency funding even as the bank battled inflation.
Powell and his deputies also effectively dismissed the possibility of further rate hikes, with the economy still strong and inflation still above policymakers’ goals. There has even been a clear preference for cutting borrowing costs to avoid acting too late and triggering a recession.
The Fed’s communications help limit volatility and help ease financial conditions overall. On the Fed’s part, this appears to be strategic and intentional, suggesting that Powell and his team have adapted to the potential threat of so-called financial accelerators, in which rising unemployment or falling incomes shock markets and amplify negative shocks , thus leading to risks of rapid economic growth.
The Federal Reserve is trying to keep its “tightening” monetary policy below boiling point. This creates a paradox. Fed officials said their policies were restrictive but financial conditions remained accommodative.
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Fed policymakers cannot micromanage every aspect of the financial system and economy. There is real pain and risk is concentrated in areas of lower visibility. Long-term high interest rates are really starting to have an impact.
“Behind the scenes, there’s more pressure,” said Jason Callan, head of structured asset investments at Columbia Threadneedle Investments. “The real key is the labor market.”
Most loans to low-income households are provided by fintech companies and are not subject to regulatory oversight. The resilience of the shadow banking system and consumers in a downturn without wage protection and stimulus remains to be seen.
“The greater the inequality, the more financial instability,” Karen Petrou, co-founder of financial sector analytics firm Commonwealth Financial Analytics, said in a recent speech. “It is increasingly likely that even small amounts of macro Economic or financial system stress can also quickly turn toxic.”
