Higher-for-Longer? Maybe Not. (September 24, 2023)

The intention to leave rates relatively high for an extended period of time may prove naive, even if inflation remains above the Fed’s 2% target. 

By Lisa Beilfuss
September 24, 2023

Federal Reserve Chairman Jerome Powell stressed in his latest press conference a commitment to holding interest rates higher for longer to quell inflation. But the inevitable cleanup may short circuit even the most earnest pledge. 

Powell said that even if monetary policy is already sufficiently restrictive, “we're going to need that to remain to be the case for some time.” It is unclear just how long “higher for longer” might be. If it is any indication, the Federal Open Market Committee’s updated forecasts show that policy makers expect rates will end 2026 above the roughly 2.5% that most of them think is the longer-run neutral rate.   

The intention to leave rates relatively high for an extended period of time may prove naive, however, even if inflation remains above the Fed’s 2% target. 

First, the Fed may have already overtightened. Looking back at all 18 tightening cycles since 1951, the average time from the last rate hike to the first rate cut is only three months, says Joe LaVorgna, chief economist at SMBC Nikko Securities America. The last five cycles have had an eight-month lag. If the Fed is done raising rates, it means the clock started in July. If history is a guide, it suggests the first cut comes in or before March 2024. 

“This implicitly means the Fed has always overtightened. If it did not, then the Fed would not have to reverse course so quickly,” says LaVorgna.  

Second, the Fed has never tightened rates from such a precarious fiscal position, says Luke Gromen, founder of research firm FFTT. The government debt-to-GDP ratio is 121%, the fiscal deficit-to-GDP ratio is about 6%, and the net international investment position, or NIIP, to-GDP ratio is roughly negative 70%, he notes. 

Consider that fiscal year-to-date federal interest payments are up 33% versus the year-ago period. That is equivalent to an extra $150 billion annually and represents one of the government’s fastest-growing budgetary line items, LaVorgna says. For context, that amount is roughly equal to the money allocated to veterans’ benefits each year.  

Third, truly higher for longer probably corresponds with intolerable market and economic devastation. 

Myrmikan Capital founder Daniel Oliver likens historical government and Fed efforts to stem economic and market declines to attempts to keep a cresting wave from crashing. He invokes historian Frederick Lewis Allen, writing in 1935 about the onset of the Great Depression. 

“Watch a great roller surging in upon a shelving shoal. It may seem to be about to break several times before it really does; several times its crest may gleam with white, and yet the wall of water will maintain its balance and sweep on undiminished. But at last the wall becomes precariously narrow. The shoal trips it. The crest, crumbling over more, topples down, and what was a serenely moving mass of water becomes a thundering welter of foam,” Allen wrote.

Fast-forwarding to more recent history, Oliver says the Greenspan Fed’s effort to keep the credit wave from cresting expanded from bank balance sheets to stock market prices. “With Greenspan’s aid, the credit wave swept over the shoals of 1987, the 1990s, the internet bust, and then the housing bust with Bernanke’s help,” says Oliver. The wave was cresting again and about to tumble in 2019 when Powell intervened to reverse QT and bail out the multi-trillion dollar repo market, propelling the credit wave to new heights, he adds.

Oliver warns we are now reaching the point where the shoals become shallower and the wave narrower. Consider that the Fed’s Bank Term Funding Program has grown to $108 billion from $64 billion at the end of March, after Silicon Valley Bank failed and prompted the creation of the emergency program. That is as losses on banks’ investment securities soar, the average credit card interest rate has risen to 24% from a pre-pandemic 17%, and bankruptcy filings have risen to 2008 levels. 

Even modestly negative assumptions–the S&P 500 earnings yield returning to 8% (the average yield from 1871 to 1990), profit margins falling by 20%, and revenues remaining static–would produce a 61% plunge in the stock market, Oliver says. But if anything like that scenario transpires, “it would topple the largest wave of all, the largest in history, the U.S. Treasury bond market.”  

The Congressional Budget Office recently said that the federal deficit this year will roughly double from 2022, to about $2 trillion. The CBO partly attributes the increase to a 20% decline in individual income taxes, reflecting shortfalls in capital gains taxes. For all the talk of a Fed put that no longer exists–or the idea that the central bank won’t come to the market’s rescue–the Fed can’t avoid worrying about the stock market because it is key to the bigger picture.

The CBO’s projections suggest that the Treasury will need to issue $3.1 trillion in new bonds over the next two years, adding to the existing stock of $32.3 trillion. That isn’t to mention the roughly $3 trillion of maturing Treasuries it will have to replace. As Oliver puts it, the question isn’t who will buy these $6 trillion in bonds; the question is at what price.

This all means that while the Fed might want to stand its ground on higher-for-longer interest rates in the face of stubborn inflation, a pivot isn’t just inevitable but probably coming sooner than telegraphed. 

The difference this time is that the wave may be too steep, says Oliver. “The degree of QE needed to lower rates will be stunning,” he says, referring to quantitative easing, or Fed bond purchases. “[It’s] not that they will not try, but they will quail at the magnitude necessary,” he says. 

The upshot, then, is potentially even bigger intervention and more inflation. The alternative is pain that financial markets and the economy may not be able to bear, even if another attempt to subvert it only makes it all the more intolerable.