The Fed’s rate hikes could mark the beginning of a difficult new economic climate

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When the Federal Reserve last week raised interest rates by the largest amount since 1994, it did more than fight inflation.

The Federal Reserve also launched a demanding test of the economy’s ability to shed its reliance on unlimited credit and tolerate higher borrowing costs for consumers, businesses and the government.

For 40 years, the formula for US economic growth has been the same: cheap money. Consumers could easily borrow to buy homes and cars. Companies, profitable or not, could tap into bond investors to fund their businesses. And Washington could afford to bail out both Wall Street and Main Street by running apparent budget deficits made possible by borrowed funds.

Whenever the stock market faltered – beginning with the 1987 crash – the Fed rushed to the rescue by cutting interest rates and flooding the markets with cash.

Those days are over, at least for now.

“It’s just a completely different environment,” said Eric Winograd, senior economist at AllianceBernstein in New York.

Bearings in China and the US show the global economy is struggling to adjust

The Fed’s three-quarters of a percentage point hike in benchmark interest rates this week marked an abrupt end to more than four decades of falling and ultimately near-zero interest rates.

The shift has rattled financial markets, sending mortgage rates to their highest levels in almost 14 years, sending bonds into their steepest slump on record and stalling speculative investments like tech stocks and bitcoin, a cryptocurrency.

If the economy adjusts, more turbulence lies ahead. Consumers, already feeling the pinch of higher prices, will pay more for credit card balances and auto loans. The least creditworthy companies will struggle to raise the money needed to hire and expand. And Uncle Sam will face tens of billions of dollars in higher annual interest bills.

American households may find the transition out of the low-interest era particularly challenging. The rise in interest rates has shut the door on mortgage refinancing, an additional source of cash for millions of homeowners last year, according to data from the Federal Reserve Bank of New York.

The high inflation that prompted the Fed to act is also making it difficult for people to grow their wealth.

“Equities, bonds and cash — we’re in a bear market for all three,” said Liz Ann Sonders, chief investment strategist at Charles Schwab & Co.

Higher interest rates are already constraining funding for heavily indebted companies like Dunn Paper, a specialty papers maker in Port Huron, Michigan, which missed an interest payment in late March. The total value of debt classified as “distressed” by S&P Global Ratings nearly doubled to $49 billion last month, including securities from companies like Rite Aid and Bed Bath & Beyond, as investors demand higher yields from such risky issuers .

The federal government, which has been spending lavishly during the pandemic, will also feel the sting of higher interest rates. According to the Congressional Budget Office, annual interest rates on the national debt will reach $399 billion this year.

However, that estimate assumes the government will pay 2.1 percent to borrow money from long-term bond investors. If instead the 10-year Treasury yield averaged this year at its current level of 3.25 percent, taxpayers would pay an additional $32 billion in interest, according to the bipartisan Committee on Federal Budget Responsibility.

The additional interest cost alone from higher interest rates is greater than the combined annual budgets for NASA and the National Park Service.

Interest rates represent the price of money, the basis of all investment and commerce.

The Fed influences Borrowing costs across the economy by controlling the Federal Funds Rate, the rate banks pay for overnight lending. This interest rate, in turn, affects mortgages and feeds into the calculations of stock and bond investors.

When interest rates rise, the certainty of Making money on a bond or a certificate of deposit these days is becoming a better financial proposition than placing a bet on a risky new technology company that may not be profitable for a few years. That explains why the tech-rich Nasdaq index is down about 30 percent this year.

Over the past seven decades, the Fed’s policy rate has traversed an extraordinary arc. From about 1 percent in the mid-1950s, the Fed’s interest rate peaked at 20 percent in 1980, before sliding for four decades to the ultra-low borrowing costs of the last decade.

Interest rates began falling in the early 1980s after Fed Chairman Paul Volcker defeated years of double-digit inflation by raising the cost of borrowing to previously unheard-of levels. Over the next two decades, the end of the Cold War and economic reform in China brought about a massive increase in the global supply of labor and capital, pushing interest rates further down. Population aging also contributed to the decline by increasing overall savings.

More recently, financial crises led to painful recessions, which the Fed sought to remedy by cutting the cost of borrowing to near zero.

The economy generally thrived during the era of falling interest rates from 1982 to 2007, known as “The Great Moderation” for its mix of low inflation and steady growth.

But the period of near-zero interest rates that followed the 2008 crisis and lasted almost uninterrupted through this year produced financial excesses: companies with chronic financial losses, kept alive by periodic cheap infusions Loan; novel investment structures that escape regulatory scrutiny; and trending stocks, which rode a wave of public enthusiasm before crashing into financial reality.

Because risk-free saving offered low returns, investors flocked to these riskier alternatives.

“Zombie” companies, which stay in business by only borrowing money to meet their interest payments, proliferated. Among them: Clear Channel Outdoor Holdings, a billboard advertising company that has lost money in each of the last two years but still made more than $710 million in interest payments.

With the stock market nearly doubling since its pandemic low in March 2020, investors have gravitated towards special purpose acquisition companies (SPACs) over the past two years. These were “blank check” stamp corporations used to buy out private companies and take them public without the usual regulatory hurdles. Many became notorious financial debacles, such as electric truck maker Nikola, which went public via a SPAC in June 2020 and saw its share price plummet to less than $6 today from nearly $80 this month. The company last year agreed to pay the Securities and Exchange Commission $125 million to settle charges it had defrauded investors by misleading them about its products, technology and sales prospects.

“Meme” stocks also became fashionable as millions of Americans invested during the pandemic. Early last year, investors at a Reddit forum highlighted shares in GameStop, a struggling video game retailer, driving it from $17 to $347. Since then, the stock has fallen 60 percent.

“A lot of foam had to come out of the markets as a result of extremely low interest rates, which are distorting capital allocation,” said Neil Shearing, chief economist at Capital Economics in London.

The Fed’s rate hikes have made investors more selective. In the bond market, investors are now demanding a higher reward before buying the riskiest securities.

In January, companies issuing high-yield or “junk” bonds only had to offer an additional yield of 2.8 percentage points over risk-free US Treasuries. Now these companies, already facing a tougher business climate due to a slowing economy, must offer investors more than 5 points of additional yield. The added expense can mean the difference between business continuity and failure for some.

Easy money also increased the value of assets – benefiting those who already had, thus widening inequality. The richest 1 percent of Americans own 54 percent of all stocks and mutual fund shares, up from about 44 percent when the Fed first cut interest rates to zero, while the poorest half of Americans now own a smaller stake, according to Fed data.

Even as the Fed promises to raise interest rates steadily over the next year, some question its ability to steer the $24 trillion US economy back to what Fed Chair Jerome H. Powell this week called “more normal interest rate levels.” ‘ signified, and to hold her there.

The Fed’s latest forecasts mean that interest rates, which were still near zero in March, will rise to 3.4 percent by the end of this year and 3.8 percent by the end of 2023, which would mean the highest level since 2008 .

“This is an economy designed for much, much lower interest rates,” said Ajay Rajadhyaksha, Barclays’ global chairman of research. “I don’t think we’ll get to 3.8 percent.”

The Fed’s aggressive, albeit belated, rate hikes are slowing the economy faster than policymakers realize, he said. This weakness will eventually force Powell to reverse course.

The World Bank is warning that the global economy could suffer 1970s-style stagflation

The Fed’s current rate hike campaign, which began in March, is intended to cool the worst inflationary spurt the US has seen since the Volcker years.

before For years during the pandemic, policymakers worried that inflation – and interest rates – were too low.

After the 2001 and 2007 recessions, the Fed cut interest rates by more than 5 percentage points to boost growth. But when it cut interest rates to near zero starting in late 2008 and held it there for seven years, officials warned that such aggressive action was not possible in response to future recessions.

The unusual recovery from the pandemic recession overwhelmed those concerns. Trillions of dollars in government stimulus, coupled with the impact of supply chain failures and the war in Ukraine, combined to push inflation to a 40-year high of 8.6 percent.

Now the Fed is forecasting that interest rates will remain at 2.5 percent in the long term, a level it has not been able to hold steady since the 2008 crisis.

Powell, who was late in recognizing the danger of inflation last year and was surprised again last month at how quickly prices rose in May, admitting the way forward is unclear.

“No one knows for sure where the economy is going to be in a year or more,” he told reporters last week.

Markets and households are losing confidence in the Fed’s ability to manage inflation

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