Here is why the Fed hiked rates above 5% and yet the US economy doesn’t break.
The last time Fed Funds were raised aggressively towards 5% and kept there with a long, hawkish pause was in 2006-2007.
And clearly something broke then: the US housing market, which broke havoc in the banking industry too and generated the biggest financial crisis in the post WWII era.
But there is a key difference between now and then.
The big money expansion in 2005-2007 was Credit-Driven.
Today, it’s Fiscal-Driven.
Economies grow above-potential if new money is getting created in large size: this can be done via the government with generous pro-cyclical fiscal stimulus (today) or via private sector credit (bank lending, etc).
And if brought to the extreme, these two sources of money creation lead to different imbalances over time.
In 2005-2007, money creation was all about private sector borrowing (blue): the US private sector leveraged up a lot to chase the housing bubble via the subprime mortgage and credit market engines.
Back then, the government wasn’t a large contributor to money creation.
In late 2007, the housing market cracked under the pressure of excessive private sector leverage.
When private sector credit as a % of GDP rise uncontrollably you often get a Credit Event – or basically: ‘’something breaks’’.
The Japanese and Spanish real estate bubble, the Asian Tigers fever, the US housing bubble, or China today.
Ok, sure – but today the story is different.
Private sector credit isn’t the source of excessive money creation and instability – the US private sector has actually de-leveraged since 2008!
Instead, it’s all about government deficits!
Today, the story is different: the scale of government deficits (orange) in 2020-2021 was enormous, and that was by far the main driver of money creation which is still circulating in the economy.
We also got another fiscal shot in 2023, while private sector credit (blue) has been moderating for 2 years now.
This means the risk this time isn’t necessarily that ”something breaks”, especially in the US.
The risk is that the US government keeps throwing fuel on the fire of a solid economy, and it might end up re-accelerating inflation and make the macro cycles more and more volatile!
What do you think happens next?