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What happens if the Fed keeps interest rates too high for too long?

What happens if the Fed keeps interest rates too high for too long?
What happens if the Fed keeps interest rates too high for too long?

The June consumer price index brought good news to Wall Street, signaling a more pronounced cooling in inflation than expected. With all eyes on the Federal Reserve’s first rate cut, Moody’s Analytics chief economist Mark Zandi discusses the state of the economy and what could happen if the Fed continues to keep rates high in the Morning Brief.

“The economy is under a lot of pressure from higher interest rates. They are causing damage. The most obvious impact is on the labor market. I mean, the number of hours worked is down, the number of temporary workers is down, hiring rates (and) quit rates are down. Job growth is slowing. Any corrections we’re getting now are downward,” Zandi explains. If the Fed continues to keep interest rates at this high level, he believes the economy could be hit even harder.

Zandi adds that the financial system as a whole is under pressure: “The yield curve is inverted, short-term interest rates are higher than long-term interest rates, and that’s a very uncomfortable situation for people in the financial system who are trying to make money on their net interest margins. That’s why I’m worried that we could see a different kind of event in the financial system.”

He says the bond market (^TYX, ^TNX, ^FVX) feels “really choppy,” suggesting a lack of liquidity and quantitative tightening (QT). He explains, “The Fed is pulling out of the bond market as part of its QT. And that means another buyer has to step in. And as it turns out, those buyers are hedge funds. And hedge funds are obviously very price sensitive… and that creates a lot more volatility and makes the bond market more fragile.”

Click here to watch the full episode of Morning Brief for more expert insights and information on current market events.

This article was written by Melanie Riehl

Video transcript

There.

Attention is increasingly focused on the current weakening of the labour market.

Even Chairman Powell commented on it further down the page this week.

If there is no interest rate cut in September, how much further weakness in the labor market do you think could occur in the coming months?

Yes, I think that would be a mistake.

I mean, I think the economy is under a lot of pressure from higher interest rates.

Uh, it, it does some damage.

Uh, the job market is the most obvious place.

I mean, the number of hours worked has gone down, there are fewer temporary jobs, and hiring and termination rates have also gone down.

Employment growth is slowing. All recent revisions have a negative impact on the reduction in estimated employment growth.

Uh, so, unemployment claims are up, you know, that might be more seasonal than anything else we’ll wait and see.

However, it seems that companies are starting to lay off more staff.

So, yes, I worry about the Fed keeping rates too high for too long.

And then of course there is another stress point in the financial system, in the banking system and in the financial system as a whole, because the yield curve is inverted and short-term interest rates are higher than long-term interest rates.

And that’s a very uncomfortable situation for people in the financial system who are trying to make some money from the net interest on their net interest margins.

And that’s why I’m worried that we could see a different kind of event in the financial system.

So, I, you know, I, I think it’s really important that the Fed takes action here and starts cutting interest rates.

Mark, what could such an event possibly look like?

And tell us a little bit more about what some of these stressors might be triggering as we talk about the broader consequences.

Well, there are some, I’ll name one, you know, the bond market feels, uh, uh, uh, really choppy.

Liquidity in the market is very low and there are several reasons for this.

Most importantly, broker-dealers, the divisions of major banks that trade in the bond market, have not grown their business and balance sheets in line with the growth in outstanding debt.

What about this national debt?

This is due to the high budget deficits and the fact that the broker-dealers have not kept up. This has to do with the capital requirements and it is not economical for the banks to invest in these broker-dealers.

And that exacerbates the liquidity problems.

The other is quantitative tightening.

You know, the Fed is withdrawing from the bond market as part of its QT.

And that means another buyer has to step in, and as it turns out, that buyer is our hedge fund, and hedge funds are obviously very price sensitive.

Uh. They’re there when things are going well, and they leave immediately when things aren’t going so well.

And that leads to significantly more volatility and makes the bond market more fragile.

So, in this high frequency environment with this QT, uh, that’s a flash point, that’s a voltage line in the system that, you know, could be reached.

Uh, it could be a problem if the Fed keeps rates too high for too long. You know, we looked at another component in there that was part of the narrative about sluggish inflation that we saw in every report that essentially went in a different direction and hurt the housing market.

It was, you know, energy, that’s probably going to continue to be one of the more volatile parts of it.

But is there a certain stability that could bring energy from here into line with the inflation rate on a future basis?

As you say, energy prices, especially oil prices, are generally rising and falling.

So that always makes me nervous.

I mean, you know, that’s the one thing that could mess everything up here.

Nevertheless, one has the impression that oil prices should remain low.

I mean, a lot of our production comes from the USA.

The frackers have done a great job of driving the recovery here in the United States.

We produce well over 13 million barrels of oil a day, Brad, just for comparison.

The Saudis and the Russians produce 8.5 to 9 million barrels per day.

We are the world’s largest oil producer by size and that has helped us fill the gap left by sanctions against Russia and production cuts by OPEC and other oil companies.

So that helped quite a bit.

Also demand.

Global demand has been rather subdued due to the weak Chinese economy and the shift to hybrid and electric vehicles, which reduces the need for gasoline to power our cars, so all the drillers …

Well, but still, I’m really worried because there are a lot of crosscurrents, global supply and demand factors that affect the price of oil that could, you know, blow in the wrong direction.

But right now it feels, it feels OK, it feels, uh, we have a, a fragile, uh, bit of calm here at the moment.

Mark Zandi.

It’s always a pleasure to spend some time with you and thanks for breaking down this CP. I’ll be reporting with us, Chief Economist, Moody’s Analytics.

Nice to see you, Mark.

Thank you very much.

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