Olga and Hugo explore how the U.S. Federal Reserve (Fed) can address recent weakness in the banking system without giving up its commitment to reduce inflationary pressures.
Hugo: Olga, nice to be going for a walk again. The last 18 months of investing have been dominated by unease about inflation and what it means for the sensitivity of bond prices to interest-rate changes.
I don’t know if we can call it a banking crisis, but clearly there’s recently been a shift in the U.S. banking system. What does that mean for inflation? One of the primary goals of the banking system is the provision of credit. Is that now impaired? And if credit is impaired, does that imply lower economic growth, which then implies lower inflation?
It seems to me that if you repair the banking system too energetically, you remove risk from the economy, and therefore you don’t change the inflation outlook. I don’t know if these conclusions are too dramatic.
Olga: Hugo, you’ve summarized precisely what the Fed is currently preoccupied with. On the one hand, the challenge is to elevate and maintain policy rates so that we move into an era of positive real interest rates. On the other hand, while the Fed has moved quite aggressively since 2022 to shrink its balance sheet, that move has been reversed following the stress that we saw in the banking sector in March.
The two policies—raising the fed funds rate while expanding the Fed’s balance sheet—are running counter to each other.
The two policies—raising the fed funds rate while expanding the Fed’s balance sheet—are running counter to each other. Raising rates restricts the availability of credit and therefore stimulus to the economy, reducing aggregate demand. This policy will reduce inflationary pressures. That’s the only lever that the Fed has to effect changes in inflation in the short term. Growing the balance sheet by providing more deposits to the banks works in the opposite direction, by enabling more money and therefore more credit to flow into the economy.
The Fed finds itself in this unfortunate situation because very, very aggressive rate rises without altering a medium- to long-term inflation/growth trade-off has meant that the yield curve has become really inverted. During a protracted period of an inverted yield curve, the spread between returns on the assets and on the liabilities is shrinking, and this is creating stress for the banks.
For this reason, we expect the Fed to walk a tightrope, providing as much money as the banking system needs while increasing or maintaining the price of credit that the system is extending to its customers. Over time, the Fed aims to reduce the inflationary pressure from excessive demand in the economy.
Hugo: In the era since the Great Financial Crisis, the Fed expanding its balance sheet has been positive for asset prices. So is the Fed undermining its efforts to fight inflation by taking stress off the banks?
Olga: Not necessarily. During the past decade, we saw a period of very low and even negative real rates, along with aggressive balance-sheet expansion and appreciation of asset prices. At the same time, we saw very anemic economic growth and inflation, not just in the United States but globally. The expansion of the Fed’s balance sheet and a sharp appreciation of asset prices can go hand in hand with very weak inflation.
It is perfectly possible to have an expanding balance sheet and very weak inflation.
This brings me to the point that you and I have been making for quite some time: Inflation is usually a function of things other than the availability of money in the banking system. It is about aggregate demand growth. It is about income growth at lower cohorts of the wage distribution. It is about skills, logistics, transport, competition—things that are very relevant to the economy but that have nothing to do with the Fed’s balance sheet.
So it is perfectly possible, since we observed it in the last decade, to have an expanding balance sheet and very weak inflation.
Hugo: When the Fed expands its balance sheet, is that usually positive for risk assets?
Olga: Unambiguously, yes. This is one of the reasons why, in the weeks following the initial stress in the banking system, when we saw that the Fed had moved to increase its balance sheet, we lowered the risk of recession back to where we had it at the beginning of the year.
Hugo: The stress in the banking system is clearly linked to the shape of the yield curve, but there also has been a loss of trust. It is likely that the move from bank deposits to money-market funds has been pretty considerable. Do you expect the deposit flight that we’ve seen to continue?
Olga: Well, as long as the yield curve remains inverted, we’re going to have this pressure. But over time, once the yield curve resumes its upward shape, that pressure on banks can go away. When it does, my best guess is that the Fed will start to think about shrinking its balance sheet again.
Olga Bitel, partner, is a global strategist on William Blair’s global equity team.
Hugo Scott‐Gall, partner, is a portfolio manager and co-director of research on William Blair’s global equity team.
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