♟️ The Fed Is in Checkmate: What Will Powell Do?

Balancing inflation, interest rates, and bank stability: Ram Ahluwalia shares insights on the Fed's dilemma and the future of the US economy.

Ram Ahluwalia, CEO of Lumida, sat down with Laura to discuss the Federal Reserve's ongoing struggle to balance inflation, interest rates, and the stability of regional banks. His insights provide a unique perspective on the Fed's current predicament and its potential impact on the US economy.

The Fed's Bond Portfolio Woes

Ahluwalia discusses the impact of the Federal Reserve's bond portfolio on its financial stability. Over the last 14 years, the Fed purchased mortgage-backed securities and treasuries during the period of quantitative easing and low-interest rates. With the fastest pace of rate increases since 1981 and high inflation, bond values have dropped significantly, causing losses in the Fed's System Open Market Account (SOMA) portfolio. Although these losses are unrealized, the situation is unique because the Fed became unprofitable for the first time since 1915 in the last quarter.

The Fed holds $8.3 trillion in fixed-rate bonds, earning about 2% per year, but also pays out interest on $5.7 trillion in liabilities. The break-even interest rate is 3%; however, Fed funds are projected to go to 5%, causing the Fed to lose money. The Fed is currently losing around $2.3 billion per week, which will increase to $2.6 billion with more rate hikes. Over one year, this amounts to a loss of $130 billion, significantly higher than the Fed's capital base of around $40 billion. 

"[As] the fixed rate bond portfolio for the Fed drops more, the Fed loses more money," explains Ahluwalia.

While this may not pose an immediate threat to the Fed, regional banks are also feeling the pressure. As interest rates rise, the bond portfolios of these banks experience a similar drop in value, as seen with the recent collapse of Silicon Valley Bank.

The Run on Regional Banks

"The more the Fed raises rates, the greater the spread between money markets and the deposit payout," Ahluwalia says.

With higher returns in money market funds compared to bank deposit accounts, corporations are incentivized to shift their funds away from regional banks, creating a slow-motion bank run. This, in turn, puts further strain on the banking system, as banks struggle to keep up with the increasing spread between money market and deposit account payouts.

The Fed's Tough Decision: Inflation or Bank Stability?

"They're in a checkmate position," Ahluwalia states about the Fed.

On one hand, raising interest rates will crush inflation and restore credibility. However, this action will also place regional banks in a precarious position. On the other hand, lowering interest rates can save the banks and reflate their balance sheets, but at the cost of maintaining inflation at higher levels. This situation echoes the economic environment of 1969 to 1974.

Ahluwalia thinks that the Fed will continue to try to tamp down inflation, because the Fed may protect banks from potential runs by guaranteeing deposits, even if it doesn't explicitly state this intention. In this scenario, the Fed would work closely with large banks, such as JP Morgan, to ensure liquidity for any struggling regional banks.

Market Expectations and the Fed's Response

Ahluwalia raises the question of whether the Fed will bow to market expectations. If the Fed continues its course of raising interest rates, it may disappoint the markets, effectively removing the "Fed put," another way to say that the Fed will pivot and stop hiking rates. However, if a systematic financial market dislocation occurs, the Fed put could return.

The European Central Bank's (ECB) recent decision to raise interest rates by 50 basis points, despite its own banking issues (like the Credit Suisse crisis), may provide insight into the Fed's upcoming actions.

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