Rutvij Thakkar, Claremont McKenna
The Federal Reserve’s dual mandate is as simple as holding unemployment below 4% and inflation below 2%. Unemployment should ideally be at the “natural rate” or the lowest unemployment rate possible without creating inflation. According to the Federal Reserve Economic Database, it’s the rate of unemployment arising from all sources except fluctuations in aggregate demand. Since the Baby Boomer generation has chosen to leave the workforce and retire, the Natural Rate—now called the Noncyclical Rate—of unemployment has consistently declined since 1980 to approximately 4%.
For the first time since February 2020, the unemployment rate in the United States was recorded at 3.4%, matching a 54-year low. A recession seemed unlikely for the foreseeable future, as GDP grew at 2.9% during the last quarter of 2022. Equity markets began 2023 roaring, and on the surface, the US economy appeared healthier than ever.
However, since February 9th, the S&P 500 has pared yearly gains down from +9% to 4%. Risk assets have reacted negatively to strong consumer spending, low unemployment, China’s reopening, and an ameliorated European oil and gas crisis. Still, equity markets and economic confidence remain unstable because the Fed has only met its first mandate. With historically low unemployment, Federal Reserve Chair Jerome Powell steered the ship to where the United States economy and dollar look stronger than ever, but prices remain untamed.
Consumer prices rose 6.4% in January, down from the 9.1% high seen in June 2022, but this was still far from the typical developed-economy inflation goal of 2%. Regardless, high economic growth combined with even higher inflation isn’t necessarily the end of the world; in fact, it casts away many of the fears of stagflation—a situation wherein the economy doesn’t grow despite the presence of high inflation.
The standard narrative for why inflation picked up so much was due to supply-chain shortages from the pandemic combined with geopolitical trade issues including the trade war with China and Russia’s invasion of Ukraine. Goods get more expensive when they’re harder to come by, a fairly predictable outcome.
However, the bigger picture for this inflationary cycle may stem from earlier fiscal and monetary policy effects. Over the course of the pandemic recovery, fiscal stimulus combined with the Federal Reserve’s lower interest rates led to inflated asset prices because savings inflows at low interest rates allowed for higher risk tolerance.
Evidence for the prior thesis is reflected in the historical data shown below:
Riskier assets seemed more attractive last year for two primary reasons. The first was based on the fundamentals of intrinsic valuation: Investors evaluate potential opportunities by discounting the future value of cash flows to the present. The concept is detailed below in simple terms:
The discount rate is determined almost entirely by the opportunity cost of “where else you could put your money,” which comes down to broader equity market returns and, very specifically, the 10-year United States treasury bond. The return on T-bonds is known as the “risk-free rate,” or where a dollar could generate the safest possible return to offset the cost of inflation. This security represents the cost of borrowing, the cost of investing, and, more broadly, the cost of capital. In order to benefit from surplus savings, investments would theoretically have to beat out the 10-year Treasury.
From April 2020 to January 2022, the yield on 10-year Treasuries hovered between 0.6% to 1.5%, making it easier for investment opportunities to beat risk-free rates. Moreover, because of the low opportunity cost associated with investing, plenty of traditional rules were thrown out the window—even opportunities that may not generate cash flows (such as cryptocurrencies and non-fungible tokens) were heavily speculated on.
The second reason so many investment theses turned towards riskier assets was the sheer amount of money in the United States and, by extension, the world economy, with the dollar still being a dominant reserve currency.
M1 Money Supply, or the total amount of checkable deposits and physical currency in the economy, spiked from about $4 billion in January 2020 to a peak of nearly $21 billion in April 2022. This means that about 80% of all dollars in circulation were created during the pandemic, and the money supply can only contract when the Federal Reserve increases interest rates—which only began in April 2022.
Regarding how dollars are “created,” the world economy now functions on a fiat currency system, meaning central banks can decide aggregate public credit availability by lending directly to consumer banks. The rate at which banks can borrow money directly from the Federal Reserve is the federal funds rate, which was hovering between 0.05% to 0.08% at the height of the pandemic. Right in line with money supply, it increased from 0.33% in April 2022 to a shocking 4.57% in February 2023.
As a result, for banks to borrow or “create” money, they now have to assume twice the cost of capital as they did before the pandemic, when the federal funds rate was close to 2%. Earlier, banks could finance projects with minimal due diligence because they could be done at a much lower cost. So within months, economic growth and leverage potentiality went from virtually unlimited to levels we hadn’t seen since pre-2008.
Essentially, raising interest rates is how the Fed conducts a controlled burn to delete some of those dollars they had “printed digitally,” as Chairman Powell put it. This is also reflected in the 10-year bond yield, which is back to 4% like it was before the 2008 recession. However, what Powell referred to isn’t akin to the Treasury printing physical dollar bills. Instead, the Federal Reserve engages in a process known as “Large-Scale Asset Purchases,” better known as Quantitative Easing. Banks typically hold government bonds on their balance sheet to prevent the currency from losing value, parking it in a virtually risk-free and interest-yielding asset.
When the 2008 financial crisis struck, the Federal Reserve began buying these assets at a premium, forcing banks to make credit easier to access. Because banks had to empty what once dominated the asset side of their balance sheet, theoretically, they would further credit lines to small businesses and consumers to stimulate spending and further innovation. During the 2008 recession, Fed Chairman Ben Bernanke argued that it would be necessary to boost capital markets.
However, this view has been compared to trickle-down economics, as commercial banks and other liquidity-injected financial institutions used unlimited credit from the 2008 recession to turn around and buy the same securities the Federal Reserve was frontrunning. Andrew Huszar, former manager of the $1.25 trillion MBS purchase program, left the Fed in 2011 for this exact reason, stating in an interview with PBS:
“[The banks] were just investing in the same bonds the Fed bought. They were taking that money and turning around and buying the same mortgage-backed securities and other bonds– why? Because the Fed had made clear that its goal was to drive up the price of financial assets. Wall Street turned around and thought, “Why would I go through the effort of making a mortgage when I can just press a button and buy millions, if not billions of dollars of bonds, and ride that trade.”
It’s been evident through how the market has reacted to monetary policy that the Fed and regulators have encouraged moral hazard, bailing out actors when they take risks and lose money and allowing them to reap profits when risk gains money. The 2008 financial crisis was driven by adverse selection, with banks engineering high-risk collateralized debt obligations and facing no criminal prosecution or market consequences because they were “too big to fail.”
2020 was also very similar, when free-market capitalism was just too harsh to let it affect financial institutions, but okay when it came to a record 14% unemployment resulting from government shutdowns. As Mohamad El-Erian, economist and former CEO of PIMCO, put it:
“Bad news for the economy was good news for markets. In the midst of all the economic turmoil, Wall Street actually closed out its best week in 45 years. Because when people saw bad news, they said, “The Fed will have to do more.”
This is how despite rising COVID deaths and skyrocketing unemployment, US equity markets saw their largest cash infusion of all time and witnessed markedly higher returns compared to the past few years, which were spent “in recovery” from the 2008 crisis.
It was the same monetary principles on steroids. The flame of the Fed’s direct asset purchasing was further stoked by fiscal policy, which put roughly $800 billion of stimulus checks in the hands of retail investors, who saw the forthcoming economic recovery and continuation of the bull market as an opportunity to strike it rich. Combine that with another $800 billion in Paycheck Protection Program loans, 92% of which won’t be repaid, and you have a recipe for an “everything” asset bubble.
A rare situation occurred where many uncorrelated securities, such as oil, crypto, stocks, and bonds, increased simultaneously between March 2020 and May 2022. To review:
- The asset bubble was fueled by low-interest rates in federal funds, which allowed banks to borrow money for cheap.
- This resulted in a leveraging of the economy, boosting aggregate demand and lowering savings rates in favor of equity investments and riskier ventures (responsible for an increase in equity valuations).
- Large-scale asset repurchasing directly increased the price of bonds as the Fed and banks loaded their balance sheets with them and lowered bond yields across the board, making bonds an expensive and relatively worthless security in the face of inflation (responsible for a rapid increase in bond prices and a sharp decline in yields).
- A crash in oil and gas futures due to lockdowns, immediately followed by the intentional inflationary cycle and the crisis in Ukraine, caused EU nations to switch to a singular source of oil and gas: the United States (responsible for the increase in oil prices).
- The massive inflation of speculative assets such as cryptocurrency and non-fungible tokens took place as a result of retail traders gaining access to commission-free trading, creating opportunities for traditional Ponzi schemes and swindlers to gain prominence (think FTX).
Essentially, a bunch of supposedly uncorrelated assets that were meant to hedge against each other all saw a simultaneous increase in prices. This can only happen when money is incredibly cheap, meaning inflation has run rampant, and every asset category other than cash is worth holding. Because of the sheer amount of dollars in the economy, it was hard for any asset class to lose, resulting in what can only be described as bad corporate behavior. Examples of this behavior range from PPP loans never being paid back to Ponzi schemes defrauding investors. Additionally, because all sorts of asset classes increased in valuation simultaneously, they crashed in tandem, dependent on one another since they were all backed by cheap money.
Predictably, capital market exuberance had several domino-effect failures in the past year. A prominent example was the collapse of cryptocurrency exchange FTX, which at one point was advertising on the Super Bowl with CEO Sam Bankman-Fried claiming that they could displace the CME and Goldman Sachs. Funny enough, the CEO of CME Group recognized early on that Bankman-Fried was a fraud when he suggested bringing crypto to the heralded Chicago Mercantile Exchange, stating:
“When you have the greatest quarterback of all time and a supermodel wife doing a commercial picking up the phone saying ‘Are you in, are you in, are you in.’ To me, it looks like a pump-and-dump scheme,” said Duffy. “People get very influenced by people like Tom [Brady].”
FTX had a meteoric rise in user deposits as crypto enthusiasts and financial novices utilized the platform hoping to make it to the next big thing before anyone else. Prominent venture capital firms like Sequoia invested millions despite Bankman-Fried playing video games during a pitch and raising a meme funding round of $420 million from 69 investors in October 2021.
If it wasn’t obvious, it should’ve been when investors looked at Alameda Research, the hedge fund that Bankman-Fried and his associates ran to manage FTX’s liquidity. Telltale signs of a Bernie Madoff-style Ponzi scheme are found in their investor prospectuses. With straight-line returns and blatant overconfidence (along with a rather unprofessional exuberance and style of delivery), Alameda guaranteed 15% returns and promised potentially higher returns if investors put in more than $200 million. This is contrary to the typical trading strategy, which achieves higher returns at a lower scale and typically struggles with higher risk tolerance once the principal grows too much.
As Tyler Gellasch, the CEO of Healthy Markets and a former SEC and Senate staffer, explained, “This is a flashing red flag for investigators. These types of documents are likely to be an exhibit in court cases. Promising high returns with ‘no risk’ is a massive red flag for sophisticated investors and is bound to give rise to criminal and civil investigations.”
This story is worth telling because it puts every wild and irrational take caused by an ultra-low interest environment into perspective. When the music stops playing, who will be left without a chair, or, as Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.” Unfortunately, however, FTX wasn’t the only corporate failure demonstrating irrational exuberance.
While there were many examples where investors blatantly disregarded the fundamentals, few were as scathingly worrisome as the bank failures of Silicon Valley Bank (SVB) and Signature Bank, which followed the collapse of FTX.
SVB was a bank out of California specializing in venture financing and lending to tech founders and their up-and-coming startups. At its peak in 2021, SVB backed over half of the new tech IPOs. Along with this overexposure, over 90% of SVB’s deposits were uninsured. However, SVB also had more assets than liabilities, and most of the companies they lent to were creditworthy or had no default risk. So how did this bank fail? Instead of their liabilities being the primary problem, SVB’s assets caused their demise.
First, recall that banks typically hold government treasuries as assets on their balance sheet. Bonds are fixed-income securities, meaning they have a coupon attached to them to pay a fixed amount, typically quarterly. As bond prices were rallied by inflation and the Fed’s purchases, market yields on US treasuries fell to all-time lows. This meant that banks were paying higher prices for assets with lower returns, and eventually, this direction would have to change.
When the Federal Reserve started raising key interest rates, bonds had to be dumped from the balance sheet. This walked back previous measures taken to shore up financial liquidity in the face of the pandemic. Large-scale asset sales, tightening the requirements for borrowing, and flagging inflation as the priority instead of growth were the hawkish signs of a Fed quickly pivoting on what had been the doctrine for several years.
Ultimately, this meant that the assets on SVB’s balance sheet declined in value rapidly, and the coupon return being generated on their held-to-maturity securities wasn’t high enough to keep up with the rate of short-term liability withdrawals.
As the asset column of SVB’s balance sheet got crushed, it was forced to start selling off its bonds and raising capital again. Unfortunately, trying to refinance in a climate where the financial system already seemed unstable was a bad idea, as their road show to pick up another $2 billion went up in flames. Upon hearing this, tech founders and VCs jumped ship and immediately began withdrawing their deposits. Now SVB had liabilities they couldn’t cover exceeding $42 billion, and the capital they were attempting to raise meant nothing.
Naturally, SVB’s deposits became insured, and the FDIC guaranteed that any liability SVB didn’t meet would be covered. While the collapse had many institutional investors worried as their losses mounted, Treasury Secretary Janet Yellen argued that the bank collapses were not systemically significant and only happened due to overexposure by SVB and SBNY in tech and real estate, respectively. Asset-liability timing was also crucial here, as SVB didn’t have a dedicated risk manager for the past few years.
Despite Secretary Yellen’s reassurances, we’ve seen fragility in the entire financial sector due to the rate hikes. First Republic Bank recently collapsed despite a $30 billion deposit contribution from larger banks such as JP Morgan and Goldman Sachs to overtake SVB as the second-largest bank failure in history by deposit size. Both banks had quite a lot in common; they were both west-coast based, had a large portion of uninsured deposits, and were overexposed to one industry.
Remember the bonds discussed earlier? The ones stimulated almost entirely by Federal Reserve open market operations? These fixed-income securities are responsible for the instability faced by regional banks, with the book value of their asset columns diminished beyond repair. Part of the problem could have also been SVB’s lack of risk controls, as throughout much of 2022, SVB had no designated Chief Risk Officer. Instead, the bank highlighted its diversity, equity, and inclusion initiatives—most likely as an effort to increase its equity valuation based on ESG.
Recently, Silicon Valley Bank’s CEO said that the prevailing narrative of SVB’s poor risk management didn’t cause the bank’s downfall: Greg Becker attributed it to the pace of Fed rate hikes and negative social media sentiment. “The messaging from the Federal Reserve was that interest rates would remain low and that the inflation that was starting to bubble up would only be transitory,” Becker said in written testimony prepared for a US Senate hearing focused on the demise of SVB and Signature Bank. However, it’s a somewhat expected move to see bank executives shift blame, so it would be reasonable to assume that there was an intrinsic issue in SVB’s risk controls.
But the SVB contagion spread uncontrollably to every regional bank, and at this point, a narrative concerning financial risk at small lenders had already taken hold. Depositors could withdraw money seamlessly due to technological advances, and they were doing just that. As a result, PacWest, Metropolitan Bank, Western Alliance, Zions, First Horizon, Comerica, and many others faced a precipitous decline in checking account deposits and, subsequently, their stock prices.
As illustrated above, at the start of May, regional banks saw an additional $5.6 billion in market cap erased after the collapse of SVB. In a surprising turn, the “retail investor” acted exactly as the efficient market would predict: Consumers took advantage of the high interest rates to bank with FDIC-insured high-yield savings accounts instead of allowing their cash to be devalued by inflation.
Anecdotally, I’ve seen an influx of promotional emails from HYSA providers ranging from Titan and Affirm to the partnership between Goldman Sachs’ retail wing (Marcus) and Apple—with savings rates going from 3.5%-5.15%. In a high-interest rate environment with sticky inflation, the FDIC has had to play M&A advisor and consolidate regional banks, often crafting creative deals for large banks like J.P. Morgan to take on the balance sheets of the failed banks.
Ultimately, elevated rates have damaged the financial system while raising mortgage rates, thereby making American households feel “poorer” and spend far less. As the Fed has attempted to grapple with inflation, Chairman Powell has made clear that a hawkish outlook will prevail. However, he acknowledged that, to some degree, the bank failures were an intended consequence of rate hikes and indicated that rate hikes would inevitably slow.
Now that we’ve detailed a handful of the financial implications of long-term interest rate hikes, we can turn our attention to unemployment. Since the regime of low interest rates, the country has become accustomed to relatively low natural unemployment, which has remained the case following the pandemic.
In fact, since December 2021, unemployment has remained below 4%, raising almost no immediate red flags. Moreover, the country adapted quickly to the pandemic by implementing work-from-home measures where necessary. Retail workers shifted to e-commerce warehouses, and as the country opened up and stimulus wore off, typical jobs became more common again. Looking purely at the numbers here, there shouldn’t be any cause for concern. However, that’s only if we don’t examine the underlying narratives. The labor market in the United States has fundamentally shifted in many irreversible ways, and I’ll discuss just a few below.
The demand for labor has remained plenty high despite the specter of technological unemployment from AI and the narrative that companies may need to “trim fat” in the face of a high-interest rate economy. Chicago Booth professor and renowned economist Raghuram Rajan noted a few of the demographic shifts that occurred in the last cycle:
“Workers are hard to find, especially when it comes to hospitality and leisure. One reason is that the labor force is missing 3.5 million workers relative to pre-Covid projections. Older workers understandably quit during the pandemic, and many did not return. Retirements still continue at an accelerated pace. And tragically, as Powell pointed out, Covid-19 also ended the lives of half a million workers in the US, while a slower rate of immigration has led to about a million fewer workers than expected. In addition, given the difficult nature of jobs in leisure and hospitality, workers have sought opportunities elsewhere in the economy.”
So, to recap, there is a labor gap, with increased retirees, slowing immigration, and too many jobs people are either not qualified to do or simply don’t want to do. Rajan posits in his article “Hard landing or harder one? The Fed may need to choose” that every time the Fed has aimed for disinflation, it has been followed by increasing unemployment. However, Powell has maintained that a “soft landing” is possible, in which low-interest recovery efforts won’t have to be torpedoed to achieve economic stability.
The layoffs we witnessed in the past year or so since recovering from the pandemic have been a drastic pendulum swing from the layoffs caused by social distancing. This time, the economy has targeted white-collar or “knowledge” workers due to artificial intelligence and other software advancements. Prominent tech companies like Google and Meta ran layoffs for bloated project manager roles, and even companies like Gap have laid off workers due to inefficient corporate bureaucracy.
Efficiency became the name of the game upon Elon Musk’s takeover of Twitter, and while Silicon Valley elites initially frowned upon his strategy to cut headcounts significantly while raising hours and in-person work, there was merit to be found in his toxic private equity-esque strategy. While remote work and “take-it-easy-Tuesdays” were great for knowledge workers, a severe recalibration was in order regarding productivity and output.
Wall Street Journal reporting indicates that layoffs in the information sector spiked 88% in March from a year prior and were up 55% in finance and insurance. Compared to this, the true focus of the labor market is currently the service sector: Companies are trying to retain blue-collar employees like warehouse workers and restaurant servers who remain in short supply, leaving many executives with no option but to lay off white-collar workers and middle managers.
So to some degree, deflation is working as expected. Jobs are rotating to focus on lower-income or what would traditionally be called “low-skilled” labor and trades. This means the expected income of workers will decline, and concurrently, so will spending. We’ve seen job listings go down, and headhunters were some of the first employees to get laid off.
The Labor Department projects that of the twenty occupations creating the most new jobs in the coming decade, about two-thirds will be blue-collar jobs that pay on average $32,000 yearly, including home health and personal care aides, restaurant cooks, fast-food workers, wait staff, and freight movers.
Simply put: We overhired. Now, the economy is correcting. Per the Wall Street Journal: “Amazon.com Inc. is cutting roughly 3% of its staff … in its retail, devices, human resources, and other divisions, but it is leaving largely untouched its hundreds of thousands of warehouse workers. Facebook parent Meta Platforms Inc. is concentrating layoffs in its recruiting and business teams as it cuts 13% of its workforce or about 11,000 people. Layoffs at Ford Motor Co., Walmart Inc., and fast-fashion company H&M are also targeting salaried and office staff rather than production or retail workers.”
So while the Fed is targeting sub-4% unemployment, the intended consequences are playing out perhaps a bit differently than imagined—however, I’m sure some economists predicted a reversion to the mean quite early on. And again, with unemployment still remaining at record lows, the Fed has continued to barrage inflation with every form of money-vacuuming possible, trying to undo the excessive recovery before the market continues to disrespect every possible fundamental metric.
While economists believe there is a significant chance of a recession this year, the goal remains a “soft landing.” In a wonderful analysis via WSJ, previous soft-landing scenarios controlling for inflation and interest rates are displayed, and shockingly, the Fed has pulled it off before:
Throughout the 1970s and 1980s, rate hikes were frequently followed by recessions—but it can be argued Chair Volcker was aiming to cool the economy because the upswings in inflation were more drastic at the time. The rate increases before 2008 and 2020 did bring painful recessions; however, those in 1992 and 1998 did not. Patterns show that hard landings typically involve external forces such as spikes in commodity prices, geopolitical instability, and large financial bubbles. We currently have some element of all of these factors at play on top of uncontrolled inflation.
That’s why there’s been constant policymaker pressure, with Senator Elizabeth Warren (D, Mass) declaring that Chair Powell is unfit for his position and holds some responsibility for the financial instability we’ve seen: “He has had two jobs. One is to deal with monetary policy. One is to deal with regulation. He has failed at both,” she said.
However, we haven’t seen any landing in the quantitative easing era, with interest rates remaining near zero for a long time. This will beg the question: Can it be pulled off again? In the best-case scenario, where layoffs are only happening to Patagonia-vested fresh faces and prices begin leveling off, I think it’s more than feasible. Chairman Powell quickly became one of the most well-known faces in American politics and culture, not due to his antics but rather due to his straightforward statements and confidence in the American economy. While geopolitical risks abound and political instability grows in the face of an upcoming presidential election, it’ll be hard to pin the blame on the Federal Reserve for creating all future chaos the economy may be in store for.
Skilled workers won’t have to stay out of the job market for long; they’ll simply have to take pay cuts or adapt to the advent of AI and large-language models taking over office chores. Portfolio managers and investors won’t face hemorrhaging losses each day either, as the S&P 500 has leveled off, and tech darlings like Tesla have seen some renewed faith. Finally, venture capitalists won’t run out of failing business ideas to throw their money at, as high interest rates and the employee-scrutinizing environment have led to people making more GPT wrappers than a chocolate factory.
In some ironic sense, the economy is operating just as we’d expect it to, with sticky inflation persisting due to an era of low interest rates, and employment remaining strong as enterprise forges on in the face of a pandemic that shackled the American populace and brought plenty of businesses to their knees. Maybe it’s the American exceptionalism talking, or maybe it’s my position of relative privilege, but the recovery has been happening under our noses this whole time. While lagging indicators such as inflation may seem terrible, realistically speaking, we should see prices go down as wages go down. We should see a massive de-leveraging as regional banks go bust and crypto startups get blown up. The Fed finally struck fear into fake innovation. In a move resonant with what the American economy needed, a cycle of high interest rates has undoubtedly begun, and America will get used to it.
The small shocks are painful but so much more necessary and tolerable compared to the entire economy going up in flames and having to be rebuilt from scratch. Concerns about America’s position on the global stage abound, with developing nations positioning themselves for different reserve currencies. However, I’d argue this was in the cards, as globalization has made international trade more widespread, and central banks would inevitably diversify their different forms of fiat.
Regardless, our currency has positioned itself strongly on the global stage. If the Fed can clean up all those new digitally-printed bills with high savings rates and fiscal conservatism, we may have our soft landing. Otherwise, considering how many “once-in-a-lifetime” financial events we’ve experienced in the past three years, we shouldn’t be surprised to see a few more.