The Federal Reserve increasing both interest rates and money supply – a confusion that is potentially a recipe for stagflation

07.04.2023 09:52|Investment Advice Department, Conotoxia Ltd.

March began with increased uncertainty among investors, particularly in the financial sector. You might say that you know it is worth the trouble when lawmakers change the rules or make exceptions to deal with a particular situation. This has happened several times in recent weeks on both sides of the Atlantic. In this article, we will look at the Fed's change of course on reducing its balance sheet and the confusion it may create in the US economy.

Summary

  • Upon the shutdown of two US banks, the Fed has provided additional liquidity solutions to banks to avoid further bank runs. 
  • Because of the additional liquidity needed, the Fed was forced to increase its balance sheet by 400 billion USD within two weeks, partially erasing the work done to reduce the balance sheet since April 2022.  
  • An increased money supply in the economy may revive the inflation's strength and, eventually – a further increase in interest rates – posing additional stress to the financial systems worldwide.
  • This may create a vicious cycle with high inflation and low (or even negative) growth, known as stagflation.
  • Gold – an asset that has acted particularly well during stagflation phases of economic cycles – has been trying out the 2000 USD price level as uncertainties about geopolitical, financial, and economic measures increase around the world.

Fed increasing liquidity. Again.

A discount window is one of the Federal Reserve's tools for maintaining financial stability by providing liquidity to the banking sector. The Federal Reserve uses the discount window to lend funds to financial institutions for up to 90 days. While this tool is generally available at all times, it is particularly popular during periods of market or institutional stress. Banks can borrow funds in exchange for collateral - typically government securities - which provides a safety net for the Fed if the loan is not repaid.

Generally, the transaction mentioned above involves a haircut – the difference between the value of the collateral and the funds lent. This gives the central bank an extra layer of security and makes it less attractive in the eyes of financial institutions.  

Upon the SVB and Signature Bank shutdown, the Fed decided to remove the haircut and value the collateral at its face value (rather than the market value), intending to facilitate the procedure and motivate the financial institutions to borrow funds from the Fed. It may have worked better than expected. During the week ending on March 15, the discount window borrowing surged to an all-time high of 152.85 billion USD, surpassing its previous record of 111 billion USD during the 2008 financial crisis. 

Source: Bloomberg

The discount window is only one of the tools for injecting funds into the financial system. The newly created Bank Term Funding Program (BTFP) provided 11.9 billion USD worth of loans in the first week of its operation. As the borrowing from the BTFP may make the financial institution seem that it is in financial trouble and therefore increase the risk of a "bank run", banks were reluctant to take advantage of this support in the first week. As the latest data have been released, we may see that something has changed their minds – the value of loans increased from 11.9 billion USD to 53.6 billion USD in one week.

Source: FRED

Based on the increased need for liquidity, it may be concluded that although there are no more public announcements of another bank in a crisis, financial institutions still need the help of the Fed to meet the needs of increased withdrawal requests from their customers.

A step back from QT

The Federal Reserve may be able to raise additional funds to provide liquidity to the financial system if needed, but this would come at the cost of increasing its balance sheet. As part of tightening monetary policy, the Federal Reserve has been unwinding assets accumulated during the Covid-19 pandemic to stimulate the economy. As a result, its balance sheet grew from just over 4 trillion USD at the beginning of 2020 to nearly 9 trillion in April 2022. It boosted economic activity, which in turn contributed to rising inflation. Since then, the Fed managed to reduce its balance sheet by 600 billion USD – it may not be much compared to doubling the balance sheet during the pandemic, but we may call it a step in the right direction. 

As a result of the recent instability in financial institutions, which led to more money being injected into the financial system, the Federal Reserve's balance sheet grew by nearly 400 billion USD within two weeks reversing more than half of its success since April 2022. 

Source: Federal Reserve balance sheet

A possible stagflation 

It may be useful to recall that the main tool for slowing economic activity is to raise interest rates, which the Fed and most other central banks around the world are now doing. Raising interest rates and increasing the money supply in the economy by the Federal Reserve could be seen as two competing activities:

- Interest rates slow the economy and increase the value of the US dollar; and

- Increasing the money supply stimulates the economy and lowers the value of the US dollar.

Suppose the Federal Reserve is forced to provide increased liquidity to financial institutions further. In that case, this may interfere with its plans for combating inflation and lead to even higher interest rates in the near future. Meanwhile, higher interest rates may lead to tighter credit conditions for all involved parties and even lower valuations of fixed-income instruments held by banks. These conditions are one of the main reasons for the recent bank closures, and as conditions deteriorate, it is particularly plausible that other banks may face the same problems.  

In fact, a study conducted after the Silicon Valley Bank crash reported that a staggering 186 regional banks in the US could face the same problems as the SVB if their customers withdrew 50% of uninsured deposits. While 50% of uninsured deposits may seem like an unrealistically large number, any increase in withdrawal requests could pose a threat to banks' already strained liquidity. The closure of regional banks may lead to the financial industry's consolidation into larger, systemically  important banks, potentially paving the way for the Central Bank Digital Currency (CBDC) in the not-so-distant future.

As the vicious circle takes turns, it may be increasingly difficult to foresee the damage done to the world economy. Still, a condition called stagflation is one that has reappeared in the American lexicon for the first time since the 1980s. In a nutshell, stagflation combines high inflation with negative GDP growth. The tight unemployment rates in the major economies, which is generally a part of negative GDP growth, may suggest that, technically, they have not yet entered stagflation. Meanwhile, most countries in the Western world may struggle to keep the GDP growth positive this year. According to economic theory, stagflation may be caused by supply-side shocks, such as increased commodity prices and disruptions in supply chains, among other reasons. Most Western countries, especially the EU and the UK, have faced these shocks due to the pandemic and the Russian war in Ukraine. 

The solution for stagflation may be particularly tricky as one part of it – inflation – asks for higher interest rates while the other part – negative economic growth – asks for lower interest rates.

Gold's time to shine

One asset generally known as the safety net during turbulent times – gold – recently touched the 2,000 USD price per ounce. Previously, the 2,000 USD price mark has only been breached twice before - at the height of the Covid-19 pandemic in 2020 and a few days after the Russian Federation invaded Ukraine in early 2022.

Source: TradingView

Even the rising interest rate environment, which is generally unfavourable for gold, has not discouraged investors from turning to their "safe haven" asset as the recent uncertainties related to the financial system evolved. 

Interestingly, according to data available from Bloomberg, not only does gold perform best in the stagflation phase compared to other phases of the economic cycle in the graph below, but could also be (highest yielding)  an asset to invest in during a stagflation phase compared to other assets.

Source: Bloomberg, World Gold Council

It may be explained by a combination of factors, such as gold acting as a hedge against inflation and a safe asset during market uncertainties. Furthermore, economic turmoil in the US may be reflected in a weaker US dollar, which is a positive factor for the price of gold denominated in that currency. Whether or not the US economy slides into technical stagflation, the increased demand for gold by virtually all market players, from central banks to retail investors, may signal that we are headed for more uncertainty this year.

 

Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)

Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.

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Santa Zvaigzne-Sproģe, CFA

Santa Zvaigzne-Sproģe, CFA

Head of Investment Advice Department

A certified financial analyst with a broad experience in financial markets obtained working as a broker and securities specialist in various financial institutions across the Baltics.

In addition to obtaining the prestigious CFA license from CFA Institute and Advanced Certificate from CySEC in 2022 as well as Investment Advisor’s license from Baltic Financial Advisor’s Association in 2019, Santa holds MBA from Swiss Business School in Switzerland and master’s degree in finance from BA School of Business and Finance in Latvia.


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76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
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