Hello from your friendly neighborhood economist. I have heard the cries, and I’m back to explain what in the world is going on with the economy right now.
If you haven’t yet read the first post on this matter, you’ll want to head over to The 2022 Inflation/Recession for Dummies because this will build off of the ideas mentioned there.
Starting from where we ended last time in our nice economics bedtime story, after COVID there was, and still is, way too much money in the economy which is what is causing the inflation. The Federal Reserve (the Fed) is the US banking system that works to provide a stable monetary and financial system for the country by making monetary policy decisions. Basically, it’s the country’s bank that tries to ensure the people of the US are prospering more than deteriorating. Some people don’t exactly agree on their methods. The Fed is the organization that has been raising interest rates exponentially. Interest rates are the additional money that is tacked onto a loan that you must pay over a certain amount of years. For example, if you take out a loan from the bank that is $10,000, the bank will ask for a percentage of interest, say 5%. So in addition to having to repay the bank $10,000, you’ll have to also pay back the 5% interest. In the thick of the COVID pandemic, the Fed assumed that inflation was going to be transitory, meaning when COVID started to ease, inflation would start to ease as well. This wasn’t the case, mainly because of the large amounts of money the government put into the economy through stimulus checks and the Small Business Paycheck Protection Program. These donations labeled the CARES Act provided $1.8 trillion to the American people, which allowed them more spending money to put into the economy.
The Fed is currently raising interest rates to make the cost of money higher so that people will be less likely to spend money in an economy that already has too much money. When one has to pay more interest on credit card loans, student loans, and mortgages, they will likely spend less money overall. This is the Fed’s way of deliberately pushing the US into a recession because when consumers spend less money, there will be less money in the economy, which will allow the markets to catch back up.
Many problems, such as bank failures, are arising because the Fed is raising interest rates faster than they have in the past 40 years. Generally, they raise the interest rates by 25 points (which correlates to a 0.25% increase in the interest rates) and then wait to see how it affects the economy. Instead of doing this benchmark raise and then waiting, the Fed raised interest rates initially by 75 points and continued to raise it without seeing the effects. It’s like the saying “Move fast and break things”. When the Fed moves interest rates too fast, things break. One of those things is Silicon Valley Bank.
There are two major reasons as to why Silicon Valley Bank went bankrupt and collapsed. First, they bought a large amount of government treasury bonds at a very low-interest rate. Government treasury bonds are long-term bonds issued by the government to finance its spending needs. Generally, these government bonds are considered extremely safe investments because the government can levy its power to always pay back your loan plus interest. However government bonds don’t pay out a lot, therefore they’re not very profitable. Silicon Valley Bank’s bonds were at a 2% interest and they were locked in for 3o years, meaning it would be hard to get back the billions of dollars they put into these bonds if an emergency struck. Silicon Valley Bank decided to invest in these longer-term bonds because they were guaranteed a bigger payout if they just waited, and because of the bank’s successes early on in the pandemic they believed they had the assets to wait. When emergency did hit with the rising interest rates, they couldn’t get their money out and struggled to sell the bonds, even at a price far less than what they originally paid for them. Nobody wanted to be locked into this kind of investment.
The second reason is that Silicon Valley Bank was famous for giving low 2% interest rate mortgages (which also average 30 years) to big tech companies, the most well-known being Zuckerberg. This was in exchange for the companies keeping their deposits in Silicon Valley Bank, which is generally good for banks since it helps with the stability of funding and liquidity management. In short, it’s always good to have cash laying around and big tech companies made that possible. When you have money in banks though, it just sits around and you don’t make very much money off of it, if you make any money at all. So when the interest rates began to rise, many companies and individuals started taking their deposits out of Silicon Valley Bank and putting them into brokerage accounts. Brokerage accounts are accounts where you can store your money, and as it sits in these accounts, it accumulates extra money just by being in them. Since interest rates were so high, people wanted to benefit from it instead of just hemorrhaging money.
These two factors came together for the final collapse of Silicon Valley Bank because they were stuck in many 30-year commitments where they couldn’t get enough liquidity to continue financing their banks, especially as clients began taking their deposits out of the bank. Therefore, collapse. Move fast, break banks.
My father has his own predictions on the next thing that will be broken: commercial real estate. Commercial real estate also indulges in these long-term 5-10 year loans. For the loans that have come to the end of their lifecycle and need to be renegotiated now, in this economy, it will be extremely hard to find a buyer. With higher loan payments for the buyer and the lack of demand for commercial real estate, since many people are still working from home, the price of buildings will continue going down farther and farther. Famous commercial real estate in San Francisco on California Street has experienced the hurt firsthand with many of the buildings losing value incredibly fast. One of the most popular buildings has already dropped 80% in value compared with its 2019 price. The decrease in value greatly hurts the investors and a majority of commercial real estate utilize bank loans which they will not be able to pay back, therefore hurting the banks. A house of cards, if you will.
“Move fast, break commercial real estate.” – Father Rooster
More banks are bound to collapse and more industries will inevitably break, something that the Fed is counting on. See, the Fed raises their interest rates until everything breaks and then everyone starts over from scratch. Something that is applicable on paper, but causes a lot of American citizens to struggle before they’re able to go back to normal. When the Fed raises interest rates it alludes to the want to push the US into a recession, and businesses realize they will make less money during a recession. In preparation for making less money, businesses have started to lay off workers in large numbers and will continue doing so until the Fed eases. Despite all the talk of a recession, the US has actually not experienced a recession yet and the businesses on the S&P 500 haven’t experienced this great loss in revenue like the Fed seemed to allude to. When looking at their earnings for the past year, the chart is in green meaning an overall positive outcome. According to the National Bureau of Economic Research, the GDP has to be negative for two consecutive quarters in order for a recession to be declared. While there has been a decrease in GDP since the pandemic, there has not been a period of sustained negative GDP.
Rising interest rates aren’t the only way the Fed is attempting to solve the inflation problem in the US. Quantitative easing is when the Fed buys mortgages on the open market to put money into the economy when it needs a boost. Right now, the economy needs less money in it so for the first time, the Fed is instead selling mortgages to the American people. This takes money out of the economy because the people are giving their money to the government, a separate entity, instead of an entity in the economy. These mortgage securities from the Fed are generally priced more reasonably than mortgage securities in the private sector to make them more appealing to consumers.
Inflation is already starting to go down in small percentages, but all the effects of the pandemic and raised interest rates continue to rear their heads. It’s impossible to predict when the economy will go back to normal, or what other strategies the Fed will have to implement before that unknown date.
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