Some have characterized the latest Fed economic forecasts as the ‘Immaculate Disinflation’
The U.S. economy continues to defy expectations with still-healthy fundamentals, but there are multiple headwinds to navigate over the next year
The last few years have proved challenging for financial institutions, and maintaining focus and discipline could be even more critical over the intermediate term
The ‘Immaculate Disinflation’ was perhaps the best characterization of the September FOMC meeting by one economist. More specifically, the updated Summary of Economic Projections (SEP) conveyed a more optimistic outlook where inflation returns near the Fed’s target without any corresponding economic pain. Exhibit 1 provides a summary of the median forecasts from the September release relative to the prior June SEP. While the inflation forecasts were little changed, the median outlooks for GDP growth and unemployment were improved. At the same time, the September projections for the path of the fed funds rate showed less rate cuts through 2025. In other words, the Fed believes it can hold the policy rate in restrictive territory for the next 2-3 years and still maintain trend growth in the economy and historically low unemployment. Some refer to this as the ‘Goldilocks’ scenario for the U.S. economy.
The economy has indeed defied expectations to this point in a cycle that has included 525 basis points (bps) of rate hikes and Fed balance sheet reduction. As noted in several past commentaries, a stimulus-fueled surge in household liquid assets is a likely source for much of the resilience, but can this trend continue over the next two years with no material economic pain? This is a primary source of debate within financial markets today.
There are valid arguments for continued economic prosperity amid still healthy fundamentals. However, others can rightfully point to multiple obstacles ahead. First and foremost is restrictive monetary policy, potentially for a longer timeframe. The risk of doing too much versus too little has emerged as a topic of discussion by multiple Fed leaders in recent weeks. Earlier in this tightening cycle, Fed leaders appeared unanimous in their fear of doing too little, pointing back to lessons learned from the 1970s inflation battle. More recently, some have expressed concern that doing too much is a greater risk now.
Beyond our borders, China is battling contagion in the country’s struggling real estate sector, which has amassed significant debt at both the corporate and local government level. The country has increased stimulus efforts of late, but a full-blown financial crisis and/or significant recession for the world’s second largest economy would clearly impact the rest of the world. For example, multinational corporations in the U.S. and Europe sell many products and services to China. Additionally, there are always geopolitical risks to the global economy, including an escalation of the current war in Ukraine. At the same time, increased political polarization across the globe could result in new geopolitical risks. Therefore, while the U.S. economy may indeed be able to achieve the soft landing forecasted in the September SEP, it will have to overcome various headwinds and obstacles to do so.
Avoiding Distractions
It has been a challenging year for financial institutions amid the most aggressive Fed tightening cycle in several decades and the longest yield curve inversion ever. This followed a pandemic and extraordinary stimulus (both monetary and fiscal) that fueled a wave of deposit inflows with interest rates at the zero bound. As liquidity has drained from the system, financial institutions have had to rely more on wholesale funding sources than they have in over a decade (see Exhibit 2). As a result, the share of non-maturity deposits (NMDs) has fallen sharply in recent quarters for both credit unions and community banks. The share of NMDs rose throughout the post-GFC era, most likely the result of Fed policies that flooded the markets with liquidity (QE) and kept interest rates at historically low levels for much of the period. This environment made it difficult for money market funds and CDs to compete.
We have recently heard arguments from practitioners for various scenarios in the coming years. Some argue that surging budget deficits in the developed world will lead to a debt super cycle that will keep interest rates high for many years to come. One could counter that position by noting that this is not a new trend, but one in the making for at least a decade if not more in places like Japan, Western Europe, and even the U.S. The demographic shift in the developed world and China for more than 20 years has been declining birth rates and aging populations. In other words, the number of savers has been rising relative to spenders, the stimulus boom of the pandemic notwithstanding. This is a disinflationary scenario.
All of this is to say that there are many potential outcomes, both near-term and long-term, that are very difficult, if not impossible, to predict. As such, we would encourage all financial institution managers to avoid the distraction of trying to position for any given rates scenario. There’s simply no reason to do so in a sound asset-liability management framework. If institutions do indeed have to rely more on non-core funding, profitability will be even more contingent upon prudent risk management practices, including asset pricing and capital allocation. Managers should also have all possible risk management tools available, particularly interest-rate derivatives. Doing so allows an institution to avoid being reliant upon making the ‘right’ call on rates or some other economic scenario.
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