While the absolute quantum of interest rate increase has, so far, been less than, say, during the late 1970s and early 1980s, and current interest rates are still relatively low by historical standards, the hikes came exceptionally fast and steep. Case in point: The federal funds rate (FFR) rose from near zero to between 4.75% and 5% currently, equivalent to a 20-fold increase. Yields on the benchmark 10-year Treasury rose from 1.52% at the start of 2022 to a high of 4.25% in October, an increase of 2.75%, or 2.8 times. Such aggressive interest rate hikes have consequences.
Jitters over the health of banks continue to roil stock markets, and as a result, financial conditions are tightening. There is a flight to safety, from smaller to larger banks as well as to low-risk money market funds. Liquidity is being drained from the global banking system, partially reversing excesses from years of quantitative easing. Many banks too are responding by being more cautious and imposing stricter lending standards. All of the above will raise the risks of a global credit crunch, affecting spending and investments. Businesses, especially smaller ones, are finding it harder to refinance and borrow from banks or raise money from capital markets. Tighter credit will most likely bring forward a global economic recession. It is also disinflationary.
This banking crisis was precipitated by the US Federal Reserve’s extraordinarily loose monetary policy during the Covid-19 pandemic, followed by extraordinarily steep interest rate hikes over the past one year. So, it is somewhat ironic that the crisis will be giving the central bank a helping hand in cutting aggregate demand and damp inflationary pressures. By all indications, the Fed (and likely other major central bankers) is nearly done with its current interest rate hike cycle — though the fallout will continue to reverberate across the broader economy.
