August 2023 – By Kyle Rohrwasser
A little history before we jump in, many people use this saying in their everyday lives, but many don’t know the origin. It was the actual origin of the idiom that comes from Homer’s Odyssey. In Homer’s Odyssey, Odysseus must pass between Charybdis, a treacherous whirlpool, and Scylla, a horrid man-eating, cliff-dwelling monster.
Although not a monster, the Fed has found itself in a situation that has one long-term solution but the timing of it will be tricky. As stated in many previous articles, the Federal Reserve has raised rates dramatically over the last year and a half, moving from 0% to 5.25%. This was done in the face of record-breaking inflation over the last 40 years, hoping the economy would slow and drive prices down. We have seen inflation fall from a 9% high in June of last year to a 3% month-end July of 2023, still short of the Fed’s 2% goal. Everything leads to lower rates eventually, but the question is, can the Fed time it correctly?
If the Fed continues to move rates up, it should slow down the economy into recession, put pressure on lending, limit new investment, decrease earnings, and increase unemployment. All of this is done on purpose to slow inflation as much as possible, but ideally, not so much that we slip into recession.
This also puts a lot of pressure on banks with debt classified as “Hold to Maturity.” Many banks have low-interest debt and would experience significant losses if forced to sell. We will most likely continue to see regional banks fail if rates continue to rise. A good note here is that nearly half of S&P 500 debt is set to mature after 2030. Top companies in the US secured very good debt for the long term when they saw the opportunity.
If rates stay elevated, we will see more stress on consumer debt as well as the interest payments on government debt. The expectation is that by 2053 it will become the highest expense, exceeding the big three (Medicare, National Defense, and Social Security). At higher rates and a current balance sheet of about 32 trillion dollars, this may have a trickle-down effect that could negatively impact the value of the dollar, treasury credibility, tax revenues, future tax law, etc…
A Hard Place:
If the Fed begins to lower rates too soon it could create a situation where inflation ramps back up, and the credibility of the Federal Reserve is called into question again. In this scenario, the Fed would likely need to increase rates again to avoid potential runaway inflation. If we saw an inflationary increase, it would continue reducing the value of the dollar even further. Although “The Rock” scenario would create this over time as well, runaway inflation can happen very quickly and cause lots of panic and irrational behavior in the short term.
So, the Fed must be diligent and quick to move depending on what economic indicators they see as too strong in either direction could make for a painful trip. Cut too soon, risk inflation refreshing. Cut too late, recession of undetermined severity.
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