Dangerous Swings in Inflation and Interest Rates

The expansionary monetary policy approved after the 2008 financial crisis, as well as sanctions imposed on Russia after the start of the special operations in Donbass, have led to a sharp rise in consumer prices around the world. Global inflation over the two-year period has grown from 3.2% in 2020 to 8.8% in 2022. To cope with rising prices, central banks around the world have introduced restrictive monetary policy measures, raising interest rates and reducing the liquidity available in the market. Nevertheless, these maneuvers were poorly received by the markets, especially those of the most economically developed countries, which have gotten used to and enjoyed near-zero interest rates and excess liquidity for too long.

Analysts, sensing the financial markets’ intolerance to the high cost of money, predicted a reversal of national monetary policy for 2024, a belief supported by a slowdown in inflation. The International Monetary Fund (IMF) projected that global inflation was actually expected to fall to 5.2% in 2024, a point and a half below the rate of 6.8% registered in 2023. However, the latest updated statistics from the IMF itself indicate that inflation in 2024 will remain at around 6%, leading to a revision of expectations for its reduction both for the current year and for the coming years. It should also not be overlooked that the current inflation rate remains even higher than the average value recorded for the twenty-year period 2000-2021.

Through 2024, the major central banks have adopted a wait-and-see attitude, leaving their prime rates unchanged or, as in the case of the European Central Bank (ECB) and the Bank of England (BOE), only slightly lowering them by 0.25% or more decisively, as has been done by the Swiss Central Bank (SCB), by 0.5%. However, the Central Bank of Russia (CBR) seems to be going against this trend: in July, it even brought the rate to 18%, the highest level since March 2022, and then allowed, through statements by Central Bank Governor Elvira Nabiulina, to suggest a prolonged period of high rates, necessary to keep inflation between 6.5% and 7% in 2024 and bring it down to 4-4.5% in 2025.

In this context of uncertainty about the real dynamics of consumer prices, attention is mainly focused on the decisions of the US Federal Reserve (Fed). At every Fed meeting in 2024, global financial markets have been hoping for a cut in interest rate, which has been held at 5.25-5.5% since July 2023. Fed Governor Jerome Powell has repeatedly said in the past that the US central bank needs more tangible evidence to confirm that inflation is indeed returning to within its 2% annual growth target before it can proceed with an interest rate cut. However, as of the end of June 2024, the US inflation rate was still high at around 3%, although steadily declining compared to the first few months of the year.

At the end of 2023, market analysts debated the possible fate of the US economy, for which either a “hard” or “soft landing” was expected with respect to the choice of monetary policy, restrictive or expansionary, that the Fed would pursue. With the expected reduction in interest rates yet to be achieved in the first half of 2024, discussions started on a third scenario (no landing), i.e. a “crystallization” of the current situation in which inflation remains above target, while target and interest rates remain at current levels for an indefinite period of time.

Regardless of the future economic, financial, or political decisions that the Fed may make, given the approaching presidential election in the United States, it is interesting to analyze how the static nature of the central bank ultimately damages the US national financial system, which never recovered from the financial crisis that erupted in March 2023. Recent statistics on the health of US commercial banks essentially do not paint an encouraging picture. According to the Federal Deposit Insurance Corporation (FDIC), an independent agency created by the US Congress to insure customer deposits and oversee the solvency of financial institutions, US banks in the first quarter of this year had $516 billion in unrealized losses on the market value of the bonds on their balance sheets. Bank of America alone had unrealized losses of $110 billion. Although the problem of these losses is only “theoretical,” since banks can hold the bonds to maturity and therefore recover their full face value if a liquidity problem arises, the need to raise capital in the short term may force banks to sell these securities at market value, thus having to record on the balance sheet the loss between the face value and the market value of the bonds themselves. This is nothing short of the problem that Silicon Valley Bank (SVB) unsuccessfully faced in March 2023.

To avoid the repeat of cases like SVB’s, in 2023 the Fed established the Bank Term Funding Program (BTFP), through which banks that needed to raise funds in loss of liquidity condition could borrow money from the Fed by providing bonds held at their face value as collateral so as not to lock in any losses due to fluctuations in their market value. The BTFP program, which was nothing more than a disguised quantitative easing (QE) maneuver, was suspended in March 2024 after the provision of 164 billion dollars. The interruption of liquidity injections has returned market operators’ attention to the Fed’s interest rate decisions, leaving many questions unanswered about the US banks’ liquidity needs. In fact, BTFP once again showed that the US financial system is not only in need but has become dependent on liquidity injections from the Fed, which has instead been shrinking since the US central bank began reducing its portfolio through quantitative tightening (QT) in June 2022.

Other inconclusive news about the state of the banking system came from the Fed’s latest stress test, published in June 2024. Although, on the one hand, the 31 banks involved, all with assets over $100 billion, have the potential to absorb losses of up to $685 billion in the event of a collapse in real estate prices and a sharp rise in unemployment, on the other hand, the Fed report noted a growing insolvency risk, associated with deteriorating credit portfolios, not only industrial, but also for credit cards. At the same time, operating profitability was found to have deteriorated, exacerbated by the decline in deposits, which in itself increases banks’ liquidity risk. S&P Global estimates that in 2023 alone, US bank deposits have shrunk by $871 billion. The second quarter of 2024 showed how capital outflows from deposits continued, hitting regional banks the hardest.

The FDCI then cast an even bigger shadow over the health of the US system as it listed 63 banks in its first quarter 2024 report, without, however, naming them as “troubled,” an increase in number from the 52 banks of the late 2023. Thus, the pressure does not seem to be easing, and regional banks continue to be most at risk. A study by the Klaros Group consulting firm, which analyzed about 4000 US banks, found that 282 banks are at risk of insolvency due to deteriorating commercial real estate loan portfolios and excessively high interest rates. In March 2024, New York Community Bancorp requested a $1 billion infusion after reporting a net loss of $252 million and credit losses of $552 million, mostly related to loans for commercial real estate. Thus, the risk of a new wave of bankruptcies does not seem to have subsided at all, and after the April 2024 bankruptcy of Republic First Bank, which had about $6 billion in assets, there were rumors of other possible bankruptcies in the US financial sector. Forecasts by Japanese investment bank Nomura are alarming, predicting at least 50 bankruptcies in the coming years. Even the Pacific Investment Management Company (PIMCO) in mid-2024, through its managing director John Murray, has warned that the likelihood of new bank failures is very high, especially for regional banks, precisely because of the heavy concentration of high-risk real loans secured by real estate on the balance sheets of financial institutions.

US inflation data for August were released on September 11, and while there were expectations of a further potential slowdown, the Labor Department instead recorded an increase of 0.3%, the highest in four months, hitting 3.2%. On September 17 and 18, it will be the Fed’s turn to announce its interest rate decision. Jerome Powell said on August 23 that it was time to change monetary policy, hinting at a rate cut, since the Fed has seen the necessary signals that inflation growth is falling within the 2% per year target. However, the central bank governor also acknowledged that he needs to weigh another decisive factor for a future interest rate decision, namely the condition of the United States labor market, which in the recent period has recorded a contraction, in line with the decline in inflation. If these statements are followed by facts, it will mean that the Fed will decide to help and protect the US economy and financial system, not wanting to bet or hope for resistance from the banking system to maintain a higher cost of money than can realistically be afforded, but at the same time it could give an additional boost to consumer prices.