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More than two years into the most aggressive Federal Reserve monetary tightening in four decades, the big surprise is that the world hasn\u2019t fallen over.<\/p>\n
While US interest rates at 23-year highs are causing pockets of pain, there\u2019s nothing like the systemic problems that so often wrecked expansions in the past. The Fed has held the policy rate at 5.25% to 5.5% for about a year and is expected to leave it unchanged at their two-day policy meeting this week.<\/p>\n
With Friday capping a run of steady economic data, investors have rolled back their expectations for rate cuts again, with only one \u2014 or maybe two \u2014 now expected by the end of the year.\u00a0<\/p>\n
Financial markets continue to digest what Chair Jerome Powell calls \u201crestrictive\u201d policy very well. The three US regional-bank failures of spring 2023 are most notable for how little they affected the economy and how quickly regulators were able to halt any contagion. Credit spreads remain tight, even among riskier bonds, and volatility is low.\u00a0<\/p>\n
In other words, something different is afoot this time, and it is catching the attention of the Federal Open Market Committee \u2014 the Fed panel that sets interest rates \u2014 and they are likely to take up the topic of easy financial conditions again this week. Here\u2019s a look at a trio of unusual features that help explain why policy may have less bite:<\/p>\n
Privatization of Risk<\/p>\n
When tech stocks started falling in 2000, and subprime-mortgage related assets tumbled in 2007, it was visible to all. As fears of losses spread, fire-sales affected more and more assets, causing wider contagion \u2014 ultimately walloping the economy.<\/p>\n
What\u2019s different today is that an increasing share of financing has come from private, not public, markets. Part of that is because of tighter regulation of publicly listed financial institutions. Pension funds, endowments, family offices, ultra-wealthy individuals and others are now more directly involved in lending through non-bank institutions than in the past.<\/p>\n
Nonbank lenders have been particularly active with mid-size firms, but they\u2019re also involved with large corporations. There\u2019s an oft-cited estimate of private credit totaling $1.7 trillion, but the lack of transparency means there\u2019s no precise official tally.<\/p>\n
Because this lending is outside the visibility of public markets, problems that do develop have less chance of causing contagion. Missed interest-payments aren\u2019t the subject of public news headlines, startling investors into herd-like behavior.<\/p>\n
Pension funds and insurance companies investing in private-credit funds are unlikely to ask for their money back tomorrow, reducing the risk of sudden stops in funding.<\/p>\n
The Caveat:<\/p>\n
Just because nothing in this area has produced a major blow-up yet doesn\u2019t mean it won\u2019t happen. A recent incident where a company shifted assets away from the reach of its lenders \u2014 part of a move to raise fresh financing \u2014 was an eye-opener for many on Wall Street.<\/p>\n
The IMF dedicated an entire chapter to private credit in their April financial stability report, and their assessment was mixed. The market\u2019s size and growth mean \u201cit may become macro-critical and amplify negative shocks,\u201d the fund said. Pressure to do deals may lead to \u201clower underwriting standards.\u201d<\/p>\n
Fabio Natalucci, a deputy director at the fund who oversees the report, said in an interview the private credit \u201ceco-system is opaque and there are cross-border implications\u201d now if the market goes through a convulsion.<\/p>\n
He worries about \u201clayers of leverage\u201d in the chain of investors, the funds and the companies they own.<\/p>\n
Government Debt Powers Growth<\/p>\n
The 1990s expansion ended in a crash after companies overextended, besotted with dreams of dot-com riches. In the 2000s, it was households that leveraged themselves, borrowing against expected gains in home equity. This time around, it\u2019s the federal balance sheet that has played an unusually large role in the expansion.<\/p>\n
Government spending and investment contributed its highest share to GDP growth in 2023 in more than a decade, and of course it\u2019s been financed with debt \u2014 which stood at 99% of GDP in fiscal year 2024, according to the Congressional Budget Office.<\/p>\n
The chart below shows how dramatic the role reversal has been between households and the government:<\/p>\n
Government debt is referred to as a risk-free asset, because it\u2019s safer than a household or company, since federal authorities have the power to tax. That means leveraging up the federal balance sheet for growth is inherently less dangerous than a surge in borrowing by the private sector.<\/p>\n
The Caveat:\u00a0<\/p>\n
Even governments can get into trouble, as the UK found out in 2022 when investors balked at plans for large, unfunded tax cuts. Rising interest rates are inflating US borrowing requirements, and warnings are cropping up that the US is on an unsustainable fiscal path.<\/p>\n
\u201cThere is almost surely a limit to how much debt outstanding there can be without the market driving yields up,\u201d said Seth Carpenter, chief global economist at Morgan Stanley<\/a>. Still, \u201cif there is a tipping point, it is hard to believe we are at it right now.\u201d<\/p>\n The Fed Is Balancing Risks<\/p>\n