Low Rates Were Meant to Last. Without Them, Finance Is In for a Rough Ride.

WASHINGTON – If a number defined the 2010s, it was 2 percent. Inflation, annual economic growth, and peak interest rates have all hovered around this level — so stubbornly that economists, the Federal Reserve, and Wall Street began betting that the low-price era would last.

That bet went wrong. And with the implosion of the Silicon Valley bank, America is beginning to reckon with the consequences.

Inflation surprised economists and policymakers by soaring after the outbreak of the coronavirus pandemic, and at 6 percent in February it is proving difficult to stamp out. The Fed has hiked interest rates by 4.5 percentage points in the last 12 months alone as it tries to slow the economy and contain inflation. The central bank’s decision next Wednesday could push interest rates even higher. And this increase in the cost of borrowing is surprising some businesses, investors and households.

Silicon Valley Bank is the most extreme example yet of an institution being caught off guard. The bank had accumulated a large portfolio of long-dated bonds, which yielded more interest than shorter-dated ones. But it didn’t pay to adequately protect its assets against the possibility of a rise in interest rates — and when interest rates soared, it found that the market value of its holdings was seriously affected. The reason: Why would investors want these old bonds when they could buy new ones at more attractive rates?

These looming financial losses helped frighten investors and fuel a bank run that brought down the institution and shook the American banking system.

The bank’s mistake was a terrible – and ultimately deadly – mistake. But it wasn’t entirely unique.

Many banks hold large portfolios of long-term bonds that are worth much less than their original value. According to data from the Federal Deposit Insurance Corporation, US banks were sitting on $620 billion in unrealized losses from securities that fell in price in late 2022, with many regional banks facing major setbacks.

Adding in other potential losses, including on mortgages that were renewed when interest rates were low, New York University economists have estimated the total could be closer to $1.75 trillion. Banks can offset that with higher deposit yields — but that doesn’t work when depositors withdraw their money, as in the case of Silicon Valley Bank.

“How concerned we should be depends on how likely it is that the deposit deductible will disappear?” says Alexi Savov, who wrote the analysis with his colleague Philipp Schnabl.

Regulators may be aware of this broad interest rate risk. The Fed unveiled an emergency lending program Sunday night, offering banks cash in exchange for their bonds while treating them as if they were still worth their original value. The setup will allow banks to temporarily escape the pressures they feel as interest rates rise.

But even if the Fed manages to neutralize the threat of bank runs associated with rising interest rates, it is likely that other vulnerabilities have grown during decades of relatively low interest rates. That could create further problems at a time when borrowing costs are significantly higher.

“There’s an old saying, whenever the Fed hits the brakes, someone goes through the windshield,” said Michael Feroli, chief economist at JP Morgan. “You just never know who it’s going to be.”

America has regularly endured financial pain caused by rising interest rates. A rise in interest rates has been blamed for helping to burst the bubble in tech stocks in the early 2000s and for contributing to the fall in house prices that helped trigger the 2008 crash.

Even more closely related to today, a sharp rise in interest rates in the 1970s and 1980s caused acute problems in the savings and loan industry that only ended with government intervention.

The logic behind the financial problems caused by rising interest rates is simple. When the cost of borrowing is very low, people and businesses have to take more risks to make money from their money — and that usually means locking up their money longer or investing their money in risky ventures.

However, when the Fed raises interest rates to cool the economy and control inflation, money moves towards relatively safe Treasuries and other fixed assets. They’re suddenly paying more and seem like a safer bet in a world where the central bank is trying to slow down the economy.

This helps explain, for example, what will happen in the technology sector in 2023. Investors have been moving away from stocks of technology companies, which tend to have values ​​based on growth expectations. Expected win bets are suddenly less attractive in a higher rate environment.

A more challenging business and financial background has quickly translated into a souring tech job market. Companies have made high-profile layoffs, and Meta announced a new round just this week.

That’s pretty much how Fed interest rate moves are designed to work: they reduce growth prospects and access to finance, dampen business expansion, cost jobs and ultimately dampen demand across the economy. Slower demand leads to weaker inflation.

But sometimes the pain doesn’t play out in the orderly and predictable way that the problems in the banking system make clear.

“It just teaches you that we really do have these blind spots,” said Jeremy Stein, a former Fed governor who is now at Harvard. “You put more pressure on the pipes and something will snap – but you never know where it’s going to be.”

The Fed was aware that some banks could find themselves in trouble if interest rates rose significantly for the first time in years.

“The lack of recent industry experience of rising and more volatile interest rates, coupled with a significant level of market uncertainty, poses challenges for all banks,” Carl White, senior vice president of regulatory, credit and learning at the Federal Reserve Bank of St Louis wrote in a research note in November. This applies “regardless of size or complexity”.

But it’s been years since the central bank officially tested for a scenario of rising rates in the formal stress tests of big banks, which examine their expected health in the event of trouble. While smaller regional banks are not subjected to these tests, the decision not to test interest rate risk is a testament to a broader reality: For years, everyone, including policymakers, assumed that interest rates would not rise again.

In their economic forecasts a year ago, Fed officials predicted that even after months of accelerating inflation, interest rates would peak at 2.8 percent before falling back to 2.4 percent in the longer term.

That’s because of both recent experience and the fundamentals of the economy: inequality is high and the population is aging, two forces that are causing many savings to slosh around the economy looking for a safe parking spot. Such forces tend to lower interest rates.

The downturn in the pandemic has turned those forecasts on their head and it is not clear when interest rates will return to longer-term lower levels. While central bankers still expect borrowing costs to stay around 2.5 percent over the long term, for now they have pledged to keep them high for a long time – until inflation is on track to ease back down to 2 percent.

However, the fact that higher-than-expected interest rates are putting pressure on the financial system could complicate those plans. The Fed will release new economic forecasts alongside its rate decision next week, providing a snapshot of how its policymakers view the changing landscape.

Central bankers had previously hinted they could raise interest rates even higher than the around 5 percent previously forecast for this year as inflation shows staying power and the labor market remains strong. Whether they can stick to this plan in a world marked by financial upheaval is unclear. Officials should tread carefully at a time of uncertainty and the threat of financial chaos.

“Sometimes you feel like the world works like an engineering,” said Skanda Amarnath, executive director of Employ America, of the way central bankers think about monetary policy. “How the machine actually works is so complex and volatile that you have to be careful.”

And policymakers are likely to brace themselves for other pockets of risk in the financial system as interest rates rise: Mr Stein, for example, had expected interest rate-related weakness to show up in bond funds and was surprised when the pain in the banking system took place.

“Whether it’s more stable than we thought, or we just haven’t reached the air pocket yet, I don’t know,” he said.

Joe Rennison contributed reporting.

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2023-03-16 18:12:43

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