Monthly Market Insights: The Fed’s Dilemma

By Dr. Sylvia Kwan

$31.4 Trillion. That’s the maximum amount of outstanding debt the US can borrow to pay its bills, and it technically reached that limit back in January. It’s nearly two times more than China’s 2021 GDP and more than six times Japan’s. And it’s the highest among world countries by a long shot. What's more telling than the massive amount of debt is how it relates to GDP, commonly called the debt-to-GDP ratio. Using that measure, US debt is hovering near 100% of its GDP, as illustrated in the chart below. Whether such a situation is fiscally sustainable depends on whether future economic growth can support rising levels of government spending.

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There's been no real progress in raising the limit since I first wrote about the debt ceiling back in February. Last week, House Speaker Kevin McCarthy initiated negotiations with proposed legislation, marking the start of what historically has been a long and painful battle between political parties. US Treasury Secretary Janet Yellen estimates that the X-date — the day when the US would default on payments — could arrive as soon as this summer. Political sparring aside, an increase in the debt ceiling needs the support of a robust economy, which would open up capacity to support increased government spending. And one of the keys to getting there? Taming inflation. 

No pressure, Fed.

What does the data show?

Last week’s lower inflation figures and data showing a slowdown in GDP and the labor market are promising signs that the Fed’s aggressive rate increases are doing the job of taming inflation and cooling a hot economy. However, those gains are weighed down by better than expected corporate earnings and rising consumer spending. Fast food chains McDonald’s, Domino’s Pizza, and Chipotle Mexican Grill all beat earnings expectations, along with consumer companies such as Unilever Plc and Nestle SA. That means that buyers are still willing to pay higher prices — at least for now. This tug-of-war between the pain and consequences of rising rates and the resistance of consumers to reduce spending creates a two-steps forward, one-step back dilemma for the Fed. 

Continued turmoil in the banking sector is complicating the Fed’s job even more. Shares of First Republic Bank sank 75% last week as depositors continued to withdraw deposits. Over the weekend, the bank was taken over by the FDIC and sold to JPMorgan Chase. Experts are predicting tighter credit conditions because of bank failures. And that means less lending, more stringent credit conditions, along with higher interest rates. The ultimate effect of a credit crunch is equivalent to that of raising interest rates. Both make the cost of capital more expensive, discouraging borrowing. So, the Fed must assess how the potential consequences of credit tightening will work itself into the economy and whether it could handle further rate hikes. Both could result in an overcorrection that could throw the economy into a recession — wiping out any prospects for a softer economic landing. 

Even if the Fed can walk the tightrope between slowing the economy just enough without triggering a recession, the debt ceiling impasse (and its potential effects) could derail the Fed’s efforts. Some believe a recession is guaranteed if the debt ceiling is not increased. 

Markets appear to be absorbing the news well. April saw mostly gains, with the S&P 500 up 1.5%, the DJIA up 2.5% and the NASDAQ finishing up flat. With uncertainty looming over the debt ceiling and future Fed hikes, many investors are in a ‘wait and see’ mode. As was largely expected, the Fed raised rates by 25 bps this week. Rates are now at a 16-year high, giving the Fed ample room to change course in the coming quarters and lower rates to get the economy moving. That would be welcome news for investors, consumers, and banks.

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Dr. Sylvia Kwan

Dr. Sylvia Kwan is the Chief Investment Officer of Ellevest.