Despite growing concerns about the stability of the nation’s financial system, the Federal Reserve is likely to increase the fed funds rate this week. Recent inflation reports provide a few hints of progress, but the overall economic picture is far from one where the Fed would stop raising interest rates.
The Week That Was
Although the core consumer price index (CPI) for February rose at a 6 percent annualized rate, there are signs of moderation. The most instructive early indicator is the six-month change in core CPI, which dropped to 4.9 percent annualized, the lowest 6-month rate since June, 2021.
The core producer price index (PPI) often leads the core CPI. The PPI is at 4½ percent year-over-year and only a 2.3 percent rate in the past six months.
Another positive sign is the improvement in the March Homebuilders index, which increased to 44 from 42, with 50 marking break-even. One positive effect of the recent bank failures is lower mortgage rates, which can help stabilize the collapse in new home activity, at least temporarily.
After surging in January, February retail sales were down slightly. However, February sales are up at annualized rate of 11 percent. The spending boom going into the first quarter is a negative for containing inflation. Without a serious slowdown in spending there will not be progress on inflation.
Things to Come
With first-quarter real growth estimated at 3 percent and inflation at 4 percent to 5 percent, spending continues to feed inflation.
The near-term outlook for interest rates assumes the Fed will soon begin cutting interest rates. We expect the Fed to continue raising rates, with a likely peak in fed funds slightly above 5 percent.
Recent bank failures confirm many have not been prepared for higher interest rates. After the Fed poured money into the economy and held interest rates near zero for well over a decade, a major upward adjustment in rates was inevitable. For a financial institution not to have expected this is inexcusable.
Contacts with my banking clients and other industry experts indicate most banks have
behaved responsibly. The only systemic risks to the economy would be an overreaction from embarrassed banking regulators.
Money, Money, Money
On Wednesday the Fed will announce its monetary policy decisions for this month. With the failure of several banks, the Fed will have to split its concern over inflation with its worries about the stability of the financial system.
Financial markets currently anticipate the Fed will raise the fed funds rate by 25 basis points, to 4¾ percent to 5 percent.
Market Forces
Stock prices moved sharply higher and lower. The S&P500 ended the week slightly above the previous Friday’s number but slightly below its key 200-day average. The Nasdaq rose more than 4 percent; however, small cap ETFs (which include many banks) fell 3 percent.
The major development was the federal government’s move to increase government
control over banks. In bailing out two badly run regional banks, the seemingly limitless expansion of government power has extended to cover all previously uninsured bank depositors.
In a free economy, markets provide discipline. They punish those who make poor decisions and reward those who make good decisions—the failure to do this is called moral hazard. The latest extension of power means regulators, rather than markets, will have greater power to allocate resources.
A government-controlled system is inefficient. It punishes the wise and prudent while rewarding the stupid and imprudent.
From a technical standpoint, stock market indicators are slightly negative for the S&P500,
very negative for small cap ETFs, and positive for the Nasdaq, at least for now.
Although the overall banking system appears to be healthy, there are problems. A current study shows 10 percent of banks have larger unrecognized losses than SVB. With the likelihood of a restrictive monetary policy lasting at least to the end of the year, more bank
failures are likely. That will make stock markets a bigger risk as well.
With the yield on 2-year Treasury Notes at 3.8 percent, the market is looking for lower short-term rates. Our economic analysis indicates still-higher rates are on the way.
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Outlook
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 13 percent
Monetary Policy: restrictive