So if you own a bank, and the value of your reserves of U.S. treasuries has declined while at the same time your level of deposits has also declined, then you are now feeling stress. Did the Fed, in their singular desire to quell inflation, embark on a pace of interest rate hikes that were too fast to allow for banks and other financial institutions to adjust? Are there other vulnerabilities within this sector that will soon be exposed?
Furthermore, if the Fed decides to stop raising rates, or even take a pause, due to worries about the financial sector, can we be sure they have done enough to get the rate of inflation down to an appropriate level? And is there a chance, that in all of this uncertainty, the financial markets will lose faith in the Fed's policy reactions and then start to panic?
The Federal Open Market Committee, which sets the Fed Funds Rate, is scheduled to meet March 22. Members will no doubt find themselves in a precarious position. On the one hand, if they proceed with their well-documented plan of raising interest rates a bit higher in an effort to ensure they are driving down inflation, then will they exacerbate the newly emerging problems for the banks?
On the other hand, if the Fed does not raise interest rates, as it previously indicated it would, how will the markets respond? Will the markets presume the inflation target will not be achieved and that the Fed's credibility is dubious? Or is the prudent course of action to take a deep breath, slow things down a bit, take a closer look at the trends and the data and allow a little more time to give everybody a chance to adjust and find their footing?
One clue about how the market might respond can be found in the yield curve. I have included a chart of the most recent data, which shows a yield curve that is extremely inverted. In a healthy economy, the line should steadily rise as you move to the right. There is a lot of debate about what is currently causing this inversion and what it means for the future, but one bad thing about it is that banks have a hard time making a profit when interest rates look like this.
Now just for the record, I believe it is still possible for the Fed in particular, and the U.S. economy in general, to navigate all these issues successfully and come out on the other side stronger than ever. In other words, there is upside risk in almost any situation, and this time is no different. I believe inflation will be brought under control eventually, and the U.S. economy can expand in the future at a stronger pace than it is currently growing.
However, I am not at all sure that is what is going to happen in 2023. At the present time, I am not forecasting a soft landing or a hard landing this year. But I am not ruling anything out. The situation is too tenuous for me to engage in any type of meaningful forecasting activity. If the Fed, with its vast amounts of resources, experience and brainpower, finds itself in a quandary, then it would be hubris for me to state I can do any better. Sometimes, we just don't know.
My only advice is that you must assiduously assess your company's risks and then vigorously work to put your business in a position of strength. For a good case study on how to accomplish these obvious-sounding objectives, study closely what just happened to SVB—and the deceptive affirmation its management and its investors received from their auditors—and then do the opposite.