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Trying to Avoid a Disaster


Trying to Avoid a Disaster

If you didn’t live in Orange County, California, or California at large in the early 90s, you’d be unaware of the pain this Southern California county lived through. The early 90s were not great times for the sunshine state. Roughly 5% of the southern employment base was wiped out between 1990 and 1993, and the state slid into a recession with house prices plummeting, construction drying up, and the vaunted aerospace and defense sector ravished.

Orange County suffered from severe mismanagement, but the Federal Reserve played its part in the county’s demise. After a long period of low-interest rates, the Fed knew it had to hike to stave off an economic downturn. Yet, a rise of an unthinkable 3 percentage points in one year was simply too much to bear. Orange County buckled as did Mexico via a devaluation of its peso. This unexpected hike crushed bond prices to levels previously unseen in the postwar era. Thankfully, corrective actions were swiftly implemented, but the Orange County example, in many ways, explains the cautious nature the Fed is taking with their current rate hikes today. 

The Fed has been inching rates higher by .50 to .75 percentage points at a time. The most recent hike will move us between 2.25% and 2.5%. Back in May Chairman Jerome Powell indicated they’d likely raise rates by 50 basis points (.50 percent) at their mid-June meeting. Yet, the June inflation data provoked a bump to 75 basis points. However, in a signal to the markets, Chairman Powell was careful with his words, indicating that a .75 rate increase was unusually large and not something to be commonplace moving forward. 

Meanwhile, the European Central Bank raised its rates by .50 points and the Bank of Canada increased by a full percentage point. Under Chairman Powell, the Fed has consistently signaled the central bank’s moves in what is being called “forward-guidance.” Critics of this strategy say this risks shackling policymakers into a course of action that they might want to deviate away from in the future. Bond yields and mortgage rates have risen more than the Fed has increased its benchmark rate this year. Chairman Powell argues that this is precisely because investors have understood the Fed’s intentions via “forward-guidance.” As such, it’s enabled the Fed to elevate borrowing costs and tamper economic growth more quickly. Proponents also cite the advantageous dampening of bond-market swings that would otherwise be caused by uncertainty (should the Fed not provide any guidance ahead of time). 

There still exists disagreement on how high rates should rise by the end of the year. Some officials are arguing for 3%, while others push higher to 4%. Former Fed Chairman Alan Greenspan is a fan of transparency. Monetary policy at its core is a cooperative endeavor. If financial markets are “cooperating” or at least understand the Fed’s intentions, nasty outcomes like Orange County can hopefully be avoided.