The economic outlook for 2022 isn’t just about rising interest rates

News from this week’s Federal Reserve meeting continues to be the hot topic in the business world, with headlines highlighting a quarter of a percentage point rising interest rates. A critical element worthy of discussion is the Fed’s strategy to reduce the size of its balance sheet, thereby reducing liquidity in the economy.

Interest rates are important, but watch the balance and cash flow. Not only are efforts to shrink the Fed’s $9 billion balance sheet contributing to higher rates, but they are also directly impacting the amount of loans and investable savings in the market.

A recent article in Barron’s addressed this issue by stating that “central bankers have signaled that they may start to reduce the balance sheet sooner and more aggressively than markets had expected”. This is what people need to look for – what plan does the Fed have to reduce liquidity in the system? This is clearly what is fueling inflation, asset values, low long-term rates and the frenzy of the economy. For business owners in particular, it will be essential to monitor and pay close attention to the impact this may have on their business and finances in the near future.

Understanding Liquidity

Market liquidity in the Fed’s balance sheet reflects the amount of money supply that is currently looking for goods. While more money in the system looks good, it ends up inflating the value of our currency.

In 2008 there was a huge liquidity crunch and the Fed had to triple the size of its balance sheet – the pandemic hit just as it was starting to subside. So, for the past 14 years, we’ve been in an economy where liquidity keeps increasing, and potentially now for the first time, we’re going to see it reverse. What we do know at this point is that there will be winners and losers, and if you’re over-leveraged, it’s going to be a tough journey ahead.

With a contraction in liquidity, our money supply begins to shrink, ultimately reducing inflationary pressure.

A move to standardization

We are now in a unique environment that we have never seen before. For context, in 2017 the Fed’s balance sheet was half its size today. And while a move to a less liquid and higher interest rate seems risky, it will lead us to a more normal and balanced environment.

Specifically in the real estate sector, we have seen investors flood the housing market looking to take advantage of the very liquid and low interest rate environment. While there are short-term benefits, local economies ultimately miss out on the multiplier effect that results from new home buyers who would otherwise buy a home and then spend to make it a home.

We cannot sustain the volatility we have seen over the past two years, and while lower interest rates may sound like a good thing, the result is that inflation is at an 40 years tall. The fact is that the Fed is raising short-term rates by 25 basis points, 50 basis points or even 100 basis points – what will matter to the business owner is if you go to a bank for a loan and your lack of cash, combined with increased costs from higher interest rates, disqualifies you for a loan.

Planning for the coming year

Business owners will have to respond by navigating through a contraction in the money supply as well as an increase in the cost of capital. These changing factors can be harmful or helpful to your business and that is why stress testing in different environments is essential.

In the end, the Fed methodically navigated an extremely difficult environment – it released liquidity into the market to help us through a global pandemic, which brought the entire world to a standstill. Looking ahead, we must now focus on recovery and what it takes to get back to a new normal – and that is by reducing the balance sheet by $9 trillion. That said, it is important to keep in mind that this reduction process will put unique pressures on the economy and businesses. It’s not a silver bullet, and it will be crucial for business owners to ensure their own balance sheet can withstand the changing environment ahead.

Comments are closed.