Jerome Powell’s Rock and Hard Place

April 7, 2023

It was a tough week for Fed Chairman Powell. 

I’ve written before that being in charge of US monetary policy (and effectively US economic growth) is no small job in and of itself. But JPow has been facing some exceptional challenges throughout his term.

First, the era of easy money was fast approaching its logical end. Ever since Alan Greenspan determined that throwing money at financial crises was the preferred solution, the fed funds rate had been diving toward zero. 

By the last crisis in 2008, they couldn’t ease any further. So they started “printing” money and pumping it into the financial system under the official-sounding euphemism known as QE.

But you can’t do that forever. 

The Fed was basically out of bullets. Greenspan, Bernanke and Yellen used up all the ammo — and left Powell with a dull butter knife for the next gunfight. 

So maybe it was good fortune (for Powell I mean — not the millions of Americans living paycheck to paycheck) that a bout of massive inflation struck in 2021. It gave him the perfect excuse to start hiking rates. 

I’ve explained before how the Fed hikes rates to combat inflation. I’ve also explained that Fed rate hikes are basically useless for dealing with this kind of inflation. 

This is what’s known as “secular” inflation. It’s the result of an imbalance of supply and demand and has to fix itself.  The best bet for the Fed to force that, would be to hike rates to a more normal level (I’m still projecting 6% before everything is said and done), slow the economy and hope the whole thing doesn’t crash too badly. 

So maybe it was actually good news when the Atlanta Fed’s GDPNow reported its estimate for the first quarter fell to 1.5% on April 5 from 1.7% on April 3 (which was down from 2.5% on March 31!) 

An economic slowdown might be moving things in the right direction.

But the reality is, no one has what you’d call a real grasp on inflation…

Loretta Mester Stays Bearish Bullish Bearish

She’s been a busy Fed mouthpiece.

Almost a year ago, Cleveland Fed President Loretta Mester was offering her predictions going into what would be the Fed’s great hike year.

Cleveland Federal Reserve President Loretta Mester said Friday she’s in favor of raising interest rates quickly to bring down inflation, but not so quickly as to disrupt the economic recovery.

That’s just genius… (#sarcasm)

Beyond that gem, she said she was in favor of a 50 basis point raise, or even multiple 50 point raises.

“I would support at this point where the economy is a 50 basis point rise and maybe a few more to get to that 2.5% [fed funds] level by the end of the year,” Mester said. “I think that’s a better path. … I kind of favor this methodical approach, rather than a shock of a 75 basis point [increase]. I don’t think it’s needed for what we’re trying to do with our policy.”

(Incidentally, around the same time, the CME’s FedWatch tracker, was indicating that the fed funds rate was likely to incrementally rise to 2.75%. Basically everyone was wrong.)

After this January’s 25 basis point hike she came out to say…

We have to do more in order to make sure inflation is on that path back to our goal of 2%,” she said.

This week she was back yet again, still trying to sound like the “dovey” hawk depending on where you get your news.  Too soon to tell?…

Or higher for longer?…

A year ago she thought 2.5% would be good enough. Now it’s over 5% — maybe. And we might not be able to get inflation back to 2% until 2025.

All of this would be confusing enough for the market except that last weekend…

Saudi Arabia Throws Down

Last weekend, Saudi Arabia dropped a tactical nuke on Chairman Powell and his Fed cohorts. 

OPEC+ announced it was cutting back its daily oil production. From the Wall Street Journal: 

A group of large oil producers led by Saudi Arabia said Sunday they would cut more than a million barrels of output a day starting next month… 

The move pretty much came out of the blue and could be considered a slap in the face of the US. 

You might recall President Biden’s “diplomatic” trip to Saudi Arabia last summer that was punctuated by the “fist bump heard round the world.”

The president went to negotiate a solution to the soaring gas prices (and inflation in general) that had been crushing the economy at home. The challenge was, he was negotiating with Saudi Crown Prince Mohammed bin Salman, a leader he vowed to make a “pariah” on the world stage while on the campaign trail. 

Turns out, negotiating with those you’ve publicly disparaged isn’t that easy. 

The Saudis agreed to a (you might say “insultingly”) modest production increase of around 100,000 barrels per day. That boost lasted until September when they pulled it back. Then in October, they cut an additional 2 million barrels of daily production.

And now they’ve announced another 1.2 million barrel cut back. Again, from the WSJ…

Taken together, the output cuts amount to about 3% of the world’s petroleum production taken off the market in seven months.

Needless to say, oil prices went ballistic on the announcement.

Brent crude, which is the international price benchmark, was trading in the $77-$78 range at the end of March. After the announcement over the April 1 weekend, prices spiked to the $84-plus range. 

Which put pressure on US prices. West Texas Intermediate (WTI — the US benchmark) shot from around $73-$74 to over $80.

I don’t need to tell you that this production cut (and the accompanying spike in oil prices) will throw gas on the fire under the inflation pot — and complicate things enormously for the Fed.

Mester made no mention of the Saudi oil production cuts. 

But she did weigh in on banks…

the US banking system is sound and that officials will be watching to see how much access to credit tightens following the recent stress, adjusting monetary policy if needed.

Talking up fighting inflation and adjusting monetary policy to address a too-tight credit market in the same week isn’t very reassuring.

And Speaking of the Banking System

JP Morgan CEO Jamie Dimon, the billionaire bankster you love to hate, recently sent shareholders his annual report.

In spite of the unsettling landscape, 2022 was somewhat surprisingly another strong year for JPMorgan Chase, with the firm generating record revenue for the fifth year in a row, as well as setting numerous records in each of our lines of business. We earned revenue in 2022 of $132.3 billion and net income of $37.7 billion…

Given the current state of things, you might wonder if JP is the only bank that knows how banking is supposed to work.

But beyond the good news about their bottom line, he also made some strong accusations where the banking industry goes. 

…the recent rapid rise of interest rates placed heightened focus on the potential for rapid deterioration of the fair value of HTM portfolios and, in this case, the lack of stickiness of certain uninsured deposits.

Ultimately it was the flight of uninsured deposits that led SVB to sell assets at substantial losses.

Ironically, banks were incented to own very safe government securities because they were considered highly liquid by regulators and carried very low capital requirements. Even worse, the stress testing based on the scenario devised by the Federal Reserve Board (the Fed) never incorporated interest rates at higher levels

The fact that Fed stress tests never accounted for higher interest rates is pretty telling in terms of how addicted the financial system has become to “zero.” (It’s kinda like the math that created the CDOs that nearly killed the financial system in 2008 never factored in what happens to their value if housing prices go down…)

This is not to absolve bank management – it’s just to make clear that this wasn’t the finest hour for many players.


So here’s Jay’s conundrum now, the more they hike to fight inflation, the more attractive even short term yields will become. (Six-month CDs are already paying upwards of 5%!) With banks still paying near zero, these rates provide a real incentive for individuals and businesses to withdraw excess cash from banks and put it where it’ll make some money. Draining deposits even more.

Paying up on those deposit accounts, on the other hand, would crush banks’ net interest margins (and their stock prices…) 

None of which is good news for banks.

But How Big is the Threat?

A recent study out of the New York University Stern School of Business provides some staggering calculations on the risks the banking sector is facing right now. 

In terms of banks’ securities holdings that are at risk…

Banks’ total securities holdings (mainly agency-backed MBS and Treasuries) stood at $5.5 trillion in December 2022. This implies that securities have lost approximately $5.5 × 14.25% = $780 billion. This is slightly larger than the FDIC’s estimate of banks’ unrealized losses on securities at year-end 2022 of $620 billion. Regardless, these are large losses, equivalent to 28% to 36% of total bank equity.

Now, if everyone holds their breath and nothing changes in the next three to five years, this loss in value would amount to nothing. But if banks were forced to realize those losses, i.e. sell their securities, the damage would be huge. 

But wait… there’s more!

The estimated losses on securities are only part of the total unrealized losses banks suffered from the rise in interest rates. Loans, like securities, also lose value when interest rates go up. Total loans plus securities as of December 2022 was $17.5 trillion. Applying the average duration of loans and securities (3.9 years), the total unrealized losses on total bank credit as of December 2022 is $17.5 × 3.9 × 2.5% = $1.7 trillion. This is only slightly less than total bank equity capital of $2.1 trillion in 2022. Hence, the losses from the interest rate increase are comparable to the total equity in the entire banking system.

If that doesn’t get your attention…

Professor Dimon concurred:

As I write this letter, the current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come.

As I’m working on this essay, short positions of Toronto-Dominion (TD Bank in the US) have surged to $3.7 billion making it the most shorted bank out there. 

The banking situation is far from over.

What’s a Fed Chairman to Do?

Suddenly everyone in the world understands the concept of interest rate risk. And how the 5% hike in interest rates over the last 12 months (that no one thought to stress test for) has put some banks in precarious financial positions. 

Higher rates will only make things that much worse. 

On the other hand, the coming price pressure from the OPEC+ production cuts promises to keep Powell and Co. on the defensive where inflation goes. 

In theory this should be a problem. But the Fed has already proved that it can “walk and chew gum” at the same time. They’ve kept interest rates high while responding to the SVB crisis by launching a new “lending” facility — the Bank Term Funding Program.

(In truth they never stopped injecting liquidity at all.)

The real problem is the cure for one crisis is fodder for the other. And you can pretty much kiss the soft landing good-bye.

Chairman Powell… Meet Mr. Rock and Mr. Hard Place

Make the trend your friend,

Bob Byrne
Editor, Streetlight Confidential