Oct. 21, 2022

The Fed Over-Steers

If you've ever ridden with someone learning to drive a car, you're familiar with over-steering." It's that time when the driver veers first one way, then overcompensates the other way, jerking the passengers from one side to the other.

Over-steering is precisely how today's Federal Reserve Board is guiding monetary policy. For 12 years, the Fed has experimented with a Zero Interest Rate Policy. I say experiment because nothing like this had ever been tried by a significant central bank before.

The Great Financial Recession, as it's called, was a time when major financial institutions teetered on the brink of failure. The rationale behind this out-of-the-normal behavior was to provide enough liquidity to bring the economy out of the severe recession of 2008. The Fed hoped to propel the economy to recovery by providing virtually unlimited, nearly free funds.

The strategy worked. The economy went on to post solid growth almost immediately. But the Fed stayed with that strategy long after the continuing stimulus was needed. The Fed only raised rates during the Trump Presidency from 2016 until 2019. With the advent of Covid, down went rates again to zero. And that's where monetary policy stood until the beginning of this year.

Wall Street called this ZIRP, Zero Interest Rate Policy, which has profoundly affected corporate and personal balance sheets. After the Fed achieved zero interest, US corporate debt doubled. In 12 years, corporations went from $6 trillion in debt to over $12 trillion. Many companies found debt to be the preferred method of corporate financing. After all, how can you beat a zero cost of capital?

Stock buy-back programs gained immense popularity as companies replaced shareholders with corporate bonds.

Consumer debt also skyrocketed, going from $2.5 trillion in 2010 to $4.6 trillion today.

It's been an incredible ride for this economy, powered by an ever-rising mountain of debt. Like any naive new driver, the Fed firmly placed its foot on the gas pedal and didn't want to let up.

That is until inflation started to raise its ugly head. After assuring us for months that any inflation was purely "transitory," the Fed earlier this year finally realized that this unending stimulus had the expected effect, inflation. And by March, the Fed began a tenuous effort to raise interest rates. But it wasn't until May that rates finally cleared one-half percent.

So it was May that marked the beginning of actual interest rates. May, that was only five months ago.

And in those five months, the Fed has taken the Fed Funds rate from 1/2% to 3 1/4%. One of the most dramatic interest rate jumps ever. After all, we started from essentially zero interest. And this increase will affect everyone, from the smallest borrower to the largest corporation.

Borrow $10,000, and your interest will increase from $250 to $3,250. Borrow $1 billion, and you interest increases from $25,000 to $3,250,000. You can see how this move in interest rates will profoundly impact the country's large corporations. Especially those companies that elected to buy out their shareholders and now have substantial debt on their books.

The total effect of all this will take months, and sometimes years, to fully develop. Most loans today have a fixed interest rate and term. So nothing will change during the life of that loan or bond. However, when bonds mature or the loans come due, the borrower will face the reality of refinancing at incredibly higher interest rates. I do not doubt that these new interest rates will ruin some people and put some corporations in bankruptcy.

And yet, as incredible as this may sound, the Fed is far from done with their rate hikes.

Just yesterday, Patrick Harker, President of the Philadelphia Federal Reserve, speaking in New Jersey, said

"We are going to keep raising rates for a while," "Given our frankly disappointing lack of progress on curtailing inflation, I expect we will be well above 4% by the end of the year."

And Harker was far from alone, there were no fewer than eight other Fed governors' speeches this week, and all said essentially the same thing: the Fed will continue to hike. Look for more and more rate hikes through next year, with the rate adjusted to at least 4%.

The Fed has painted itself into a corner, late in fighting inflation, and now they want everyone to know they're serious about raising interest rates.

Like the new driver who swerves from side to side, I guess that before this tightening is complete, we'll be back to stimulus again.

 

Econ Briefs

 

Overnight, Japan reported that inflation in the land of the rising sun rose by 3%. That level of inflation may not seem like much to the US, but this is a big deal in Japan. Japan has seen inflation this high only twice in the last 20 years. Energy prices have been driving these rising prices in Japan and worldwide. With electricity rising at more than 21% and gas up nearly 20% in the latest reading.

What
Washington likes to call an inflation issue is a global energy crisis. Those countries that supply their power perform well. And those countries that rely on energy imports suffer from those higher prices. Japan, of course, is a major energy importer.

It looks like
Apple Computer will soon be feeling the pinch from China's Zero Covid Policy. In the complicated way that Apple produces iPhones, Taiwan-based Foxconn operates the largest iPhone factory in Zhengzhou, China. Foxconn has just announced that Chinese authorities have restricted factory workers, they must now eat alone, and some have reported that they must move to factory dormitories to limit social contact.

It appears that the factory may continue to operate under these restrictions. However, there is always the lurking threat of closure. And remember, there is a mysterious connection between Covid restrictions and Chinese authority's retaliation for Apple's corporate moves.
The recent move by Apple to source semiconductors away from China, maybe the real cause of this virus outbreak.

Closer to home, Baker Hughes will report on the number of
active oil wells in the country. Remember that as recently as 2019, oil companies were drilling nearly 900 wells, 50% more than today. Oil drilling has flat-lined in the 600-plus range since July. And there seems to be a natural reluctance by the oil companies to spud in new wells in light of the Biden Administrations' goal of "transitioning" the country away from fossil fuels.

In earnings, a fair amount of red, as traders are showing disappointment in some corporate results.
Verizon Communications, American Express, HCA Healthcare, and Regions Financial are trading lower in the pre-market on their earnings. Conversely, oil services companies Schlumberger, auto safety company Autoliv, and Simply Good Foods are trading higher on their results.