News & Insights

Since early 2020 the economy has undergone a series of shocks. First came the Covid-19 pandemic, which continues to impact the economy more than three years later. Next came the war in Ukraine, impacting global oil and wheat markets.

Most recently the emergence of Generative Artificial Intelligence (GAI) is a technological development that some have said could be as profoundly positive as the invention of the internet, mobile devices and cloud computing. Only time will tell if GAI lives up to the hype, but these shocks have brought tremendous volatility to the economy and financial markets.

Unprecedented monetary and fiscal support in response to the pandemic has brought elevated inflation. Since March 2022, the Federal Reserve has been pursuing monetary tightening, resulting in the fastest pace of rate hikes in U.S. history, eleven separate increases bringing the federal funds rate to a range of 5.25%-5.5%. The Fed is attempting a soft landing for the economy, raising rates just enough to slow growth without causing a recession.

The U.S. economy is still feeling the after-effects of the Covid emergency more than three years after it began. In the early going, consumers hoarded items they feared would be in short supply like toilet paper and cleaning products. Demand for many types of services like travel and dining collapsed. In the next phase, component shortages caused prices of many goods to surge. Then, as Covid restrictions eased and demand returned, labor shortages led to further price increases. The war in Ukraine exacerbated growth and price challenges.

The government played a role as spending levels and easy monetary conditions were left in place for too long even as the worst of the crisis had clearly passed. The Federal Reserve was caught flat-footed, assuming the nascent surge in inflation two years ago to be “transitory.”  It has spent the last year and a half making up for its initial failure, raising short-term interest rates from around zero to 5.00%.

The chattering class in the media and in Washington D.C. is wailing about the debt ceiling, but stock and bond market behavior suggests little concern. Treasury Secretary Janet Yellen says that there is only enough financial flexibility to avoid default until early June, so this matter is coming to a head. President Biden and the Democratic Senate insist on a “clean” bill to raise the debt ceiling which seems unlikely to pass the Republican-controlled House. Republicans insist on spending cuts and a slowdown in future spending growth as a condition of raising the debt ceiling.

The concept of a debt ceiling has not always been part of U.S. finance. From the founding of the Republic until 1917, each and every bond issuance was approved by Congress. Article I of the Constitution specifically empowers only Congress “To borrow money on the credit of the United States.”  During World War I, Congress enacted the Second Liberty Bond Act, permitting the Treasury Department to borrow without prior congressional authorization, as long as total debt didn’t exceed the approved amount. The debt ceiling was born.

The Economist, a British news magazine, put a cowboy on the cover of its April 15 issue and sang the praises of America’s resilient economy. They wrote, “America remains the world’s richest, most productive and most innovative big economy. By an impressive number of measures, it is leaving its peers ever further in the dust.”

Indeed, while Britain and much of continental Europe are experiencing recession, U.S. GDP expanded 2.6% in the fourth quarter, with the Federal Reserve Bank of Atlanta forecasting 2.5% growth for the recently-completed first quarter. After a volatile period during the pandemic, we appear to be regaining our old form of consistent real GDP growth above 2%. Although some forecasters are contemplating a late-year recession, almost no one expects a deep or long-lasting one.

The bill has seemingly come due for the Federal Reserve’s mistaken belief inflation was “transitory.”  A late start in tightening policy to combat inflation led to the fastest rate hikes in forty years, and it should come as no huge surprise the stress from such a move might break something. The collapse of Silicon Valley Bank (“SVB”), the 16th largest bank in the U.S., was the headline casualty, but Signature Bank was also shut down by regulators and the impact was evident across the sector, notably regional banks where share prices declined sharply.

Given the potential for widespread market disruption, regulators stepped in with a package of emergency measures to calm fears among depositors and help prevent contagion. The actions taken brought back unwelcome memories of the financial crisis. The government announced the FDIC would guarantee all deposits held at SVB and Signature Bank, even those beyond the $250,000 limit, by invoking a “systemic risk exception.”

The year is off to a better start for equities than many expected following a difficult 2022 when aggressive rate hikes to counter inflation weighed on sentiment. The move higher for stocks in 2023 has been prompted by the expectation that the Federal Reserve is nearing the end of its rate hike cycle as inflation retreats from its recent peak. Combine that with optimism regarding a reopening in China and a resilient labor market in the U.S., increasing hopes for a “soft landing” for the economy, and the move higher for equities is understandable.

To battle persistently high inflation the Federal Reserve has raised its benchmark interest rate by 4.5% since last March, to a range of 4.5%-4.75%. This represents the fastest pace of rate increases since the 1980s with the intention of cooling off the economy to bring down inflation. The tagline the Fed uses is that its policy operates with long and variable lags, but still, its efforts have not yet had quite the bite many expected.

Last summer, there was a brief wave of optimism among investors that the Federal Reserve’s pattern of interest rate hikes would be short-lived.  It was illogical given rampant inflation, but investors could let their imaginations wander during the lengthy eight-week lull between the Fed’s July meeting and its September meeting.  However, midway through the lull the Fed became concerned investors weren’t getting the message, using the annual “Jackson Hole (WY)” monetary policy conference in late August to reiterate its determination to raise rates until inflation is back to its 2% objective.  Investors got the message and stock and bond prices wilted for about a month and a half afterward.

A greater disconnect between markets and the Fed emerged after markets bottomed in mid-October, persisting even in the face of two more Fed meetings that resulted in rate hikes.  Notes from its November meeting indicate Fed governors raised their terminal Fed Funds rate in this tightening cycle compared to their consensus after the previous meeting.  Markets initially flinched on this news, but quickly resumed their ascent.

No year is without surprises. As we look back at 2022, probably the two most disruptive surprises were Russia’s war in Ukraine and the persistence of Covid lockdowns in China. Both caused complicated knock-on effects for the global economy. Embargoes on Russian imports stressed European energy markets and briefly caused oil and gas prices to spike worldwide. That Russian energy did not disappear, it just got rerouted, and energy commodities have pulled back significantly, although regional prices can vary compared to global averages.

Chinese demand for imports has dropped, while its export machine continues to hum despite the lockdowns. China’s balance of trade (exports minus imports) has risen to new highs. Chinese companies reselling cheap Russian energy at a markup may exaggerate this statistic.

The stock market continues to be driven on a daily basis by the outlook for interest rates. Data suggesting inflation is easing or the economy is slowing is favorably received by stock investors who are looking for, or more precisely hoping for, signs the Federal Reserve is ending its aggressive rate hikes. Every speech from Fed Governors is scrutinized for these signs.

We saw a similar pattern during the summer, but it didn’t last. Some investors didn’t believe the Fed would continue raising rates by three-quarters of a percent each month past the first couple of months. Traditional rate hikes are typically one-quarter or one-half percentage point per month, but this time the Fed started very late and attempted to make up for lost time. Summer optimism is easier to perpetuate because the Fed doesn’t meet in August, allowing investor sentiment to go off on a tangent without a reality check. But Fed Governors saw this market optimism and in mid-August doused it with a bucket of ice water, sending stocks down to new lows by the middle of October.

Despite the Federal Reserve enacting the most aggressive interest rate hikes since the 1980s, inflation continues to run near 40-year highs. In September, the Consumer Price Index (CPI) rose a greater-than-expected 8.2% from the prior year, and 0.4% from the prior month. The annual increase was down slightly from 8.3% in August and 9.1% in June, which marked the highest inflation in 40 years. The “core” measure of inflation, which excludes food and energy prices, rose 6.6%, accelerating from August and representing the largest increase since 1982. This was not welcome news, as the Fed had hoped more restrictive policy would have had a greater impact. Instead, inflation remains well north of the Fed’s 2% target.

The Fed’s preferred inflation measure, the personal consumption expenditures price index (PCE), is also running well ahead of its long-term target, rising 6.2% in August, which is the most recently available data. This is down slightly from July, but the core measure jumped to 4.9% from 4.7% the prior month.