Inflation and Technology Make this Tightening Cycle More Precarious

Monetary policy is a perennial driver of economic cycles. Periods of easy monetary policy and ample liquidity support borrowing and risk taking while the withdrawal of that liquidity and tighter policy cause borrowers and investors to retrench.

What’s unique about each cycle is the specific type of risk that builds in the “easy” period and as a result, what excesses form. That helps define what might break as central banks take away the liquidity punchbowl and what medium-term responses, such as regulatory policy or investor behaviors, result.

The challenge is always identifying the vulnerable pockets of excess and related contagion channels before monetary tightening leads to their unravelling. In the last pre-pandemic cycle, many saw the housing bubble before it burst, but very few appreciated how it would feed through the economy and financial markets, both domestically and globally.

Today, while we increasingly recognize the excesses that were formed from the last decade of near-zero interest rates and ample liquidity, we are still in the early stages of appreciating how their reversals will play out. In and of itself, that uncertainty warrants prudence, both for businesses and investors. But there are two additional reasons to approach the coming period with an added degree of caution: central banks’ need to reduce inflation and the influence of technology on the speed of contagion.

Twice just over the last decade, in 2013 and again in late 2018, the Federal Reserve quickly backed away from tightening when it saw its actions contributing to financial instability. The pivot-induced fall in yields provided a figurative financial trampoline that helped cyclical assets bounce. Today, however, inflation is more than double the Fed’s target, with service-sector wages especially difficult to tame in a strong labor market. The Fed could slow or even pause rate hikes near-term in the wake of the recent banking failures to gauge economic fallout. A near-term pivot to easing, however, as happened in the past and is discounted in markets to start later this year, seems very unlikely without a much greater financial-stability threat that would overwhelm inflation concerns or a rapid softening of the labor market that helped bring down inflation. It’s worth noting as well that the inflation challenge is not limited to the Fed; many central banks are facing similar dilemmas (as was seen in the United Kingdom last fall). This is effectively a global tightening cycle – the fallout today will come from broadly higher rates and Quantitative Tightening rather than from just one country.

Meanwhile, technology that has been more widely adopted over the last cycle has created 24/7 news (and at times, misinformation), often via social media, and has allowed investors to move capital more cheaply and easily with a touch of their phones. While there will be many lessons from the demise of Silicon Valley Bank, certainly one will be its incredible speed – speculation and news spread real-time and led to billions of deposit outflows in just a few days. In today’s world, contagion can happen quickly, even if it isn’t sustained. Such sentiment and capital swings suggest a higher-volatility world has greater potential to persist, something investors, businesses and policymakers will no doubt be grappling with going forward. Meanwhile, a “resolute,” inflation-focused Fed suggests pressure on liquidity-sensitive assets like growth stocks, capital-intensive tech start-ups and digital assets will not abate soon.