Feeling the squeeze
Is the Fed losing ground to an economy that just won’t quit? Jackson Hole and other recent commentary seems to imply this might be the case. Unemployment remains stubbornly low and inflation sticky. Consumers keep spending and savings are strong. As the tug of war rages on, signs point towards continued tight monetary conditions or a “higher for longer” Fed policy stance. It’s not to say their tools aren’t effective, it’s more of a question of how effective they can be at fighting recent structural changes to our economy that may prevent them from reaching their stated 2% neutral rate of inflation anytime soon.
If rates hover at these levels (or even rise further) for another year or more, what happens to the economy? Let’s put aside loan maturity and refinance risk for a moment. With over $1T of loan maturating annually for the next few years, this is an important, but separate category of risk, that has a yet to be known impact on main street economics.
As high interest rates work their way through the system like a termite infestation ripping through a wood building, the structure of our economy slows and weakens. New business and real estate development, the lifeblood for business expansion and growth, grinds to a stop. New deals no longer pencil. Capital is no longer willing to take risk in the face of a slow growth environment, especially when lower risk options yield over 5%. The “new” or “growth” part of our economy starts to disappear. Capital sits on the sideline waiting for better risk-adjusted opportunities in the months ahead.
Somewhat unique to this cycle has been a strong overlay of inflation. While growth slows, mostly affecting the top line, wages and COGS climbs and other aspects of owning, like property taxes and insurance, continue to increase, decimating the bottom line. These are costs fueled by reactive gov’t budget needs and an insurance industry reeling from catastrophic losses. Suddenly everything related to running a business is more expensive. Investment in business and real estate sputters.
What remains once growth stops? The legacy aspects of a business now carry a large share of the economic load. Eventually, they too fall victim to the higher interest rate environment as a business without growth prospects inevitably starts to shrink. With less new business to pursue and bottom line to reinvest, the layoffs begin and the Fed gets to its stated goal of higher unemployment, and a reason to back off high interest rates.
We all want to know how long it takes for this to play out? If forecasts are accurate, expect deuteriation in Q1 2024 and rate cuts by mid-2024. From there, the cycle begins again, hopefully putting us in the early days of a new growth pattern by 2025 – 2026.