the march 22 interest rate decision by the federal open market committee fomc was surrounded by more uncertainty than usual because of the new problems in the banking sector eight days later the gdp growth rate for 2023q4 was revised downward why did the fed continue to raise rates what’s the state of the economy and will real estate suffer from it the most important thing to remember when evaluating fomc decisions is that the fed tries really really hard not to surprise market participants there are two big reasons for that the first is that they don’t want to make inside information valuable enough for investors to break the law to get it the second is that they want to be able to surprise the market when it really matters—as they did for example in october 1998 when they cut rates even without an fomc meeting the “no surprises” rule works especially well when fomc participants are generally unanimous in their views as they have been for the last six consecutive meetings in such a situation early warning of a change in fed policy is likely to come from those members who at a given time are most likely to break the unanimity when rates are generally going down the “hawks”—the members who express the most concern about inflation—are quickest to talk about raising rates to fight it these days though the “doves”—the members who express the greatest concern about unemployment—are quickest to talk about cutting rates to fight it raphael bostic the president of the atlanta fed is one of the doves so when he starts expressing concern about further interest rate cuts that’s an indication that the unanimity may be softening while he is not currently a voting member of the fomc—votes rotate among the regional bank presidents—nonvoting regional bank presidents still participate so far though he has said nothing of the sort in an essay and an accompanying video president bostic laid out five explicit conditions he “will need to see to consider reversing the course of monetary policy”   a narrowing of the gap between labor supply and demand   reduction in the breadth of inflation let’s consider each of them narrowing the gap between labor supply and demand this can mean either of two things the demand for workers starts to soften or the supply of workers starts to increase there’s no sign yet of the first but february brought the first meaningful signs of the second as pointed out two weeks ago the employmenttopopulation ratio has increased for several vulnerable groups of workers tracked for their earlywarning value   young adults 1624 up from 508 to 523 over the past 10 months   white women up from 540 to 545 over the past three months   black adults up from 579 to 598 over the past six months   adults with less than a high school diploma up dramatically from 439 to 455 during february those increases mean not only that the workers who most need the support of a strong labor market are getting it they also mean that they are responding by rejoining the labor pool—increasing labor supply to meet labor demand as the doves want to see consumption retail spending and other measures of aggregate demand have softened from the aggressive postpandemic sprees but it has been difficult to discern whether the softening means that “higher interest rates are more decisively affecting aggregate demand” or simply that the pentup demand for certain types of spending—such as vacations—has been met the fact that the final estimate of 2023q4 gdp growth was revised downward though at least adds to the evidence that aggregate demand is softening that’s because the downward revisions didn’t come from those segments of the economy where there was likely pentup demand except for one motor vehicle maintenance and repair instead they came in exports of other business services including professional and business management consulting as well as research and development services and in domestic financial services and domestic other services led by personal care services so there is some evidence that the aggregate demand condition is on its way to being met this condition is probably the most difficult to assess supplychain problems are not nearly as obvious as they were during the pandemic and its aftermath—but the war in ukraine disrupting energy and food markets and the strained relations with china disrupting manufacturing relationships mean that the risk of supplychainrelated problems remains high in short this condition has to be rated as “not clear yet” reduction in the breadth of inflation what this means is that the fed wants to see inflation decline across the board—not just for a few of the goods or services that have the biggest impact on the overall price index gasoline prices for example are notoriously volatile and a big part of consumer spending so a decline in gas prices could easily make it look as though inflation has been conquered even if it’s still raging in other parts of the economy this part of the battle though seems well on its way to being won for example the san francisco fed produces measures of “dispersion of inflation” that measure the percent of all goods and of all spending for which prices increased and the percent for which they declined last february only 39 of all goods declined in price while 961 showed price increases—a “breadth of inflation” 922 the difference between those two figures that the country hadn’t seen since august 1981 when cigarchomping fed chairman paul volcker had pushed the federal funds rate up above 22  to fight it over the past 11 months though the breadth of inflation measure has fallen to just 725—not quite where it needs to be around 50 but a whole lot closer to “perfect” than to “light my cigar” the final condition laid out by atlanta fed president bostic is for consumers’ expectations of future inflation to recede to an acceptable level according to the new york fed’s survey of consumer expectations the median level of inflation expected over the next three years peaked at 42 in late 2021 but has declined completely to an entirely unthreatening level of 27 in february 2023 the oneyear expectation has not yet reverted entirely to the acceptable range—but its decline from 68 in june 2022 to 42 in february 2023 means it has covered almost twothirds of the necessary ground as with the breadth of inflation this battle is well on its way to being won the economy has made great progress toward achieving all five conditions set out by atlanta fed president bostic—but inflation has not yet been “whipped” in fact the only reason that some market participants expected the fomc to back away from its inflationfighting rate hikes is the trouble in the banking sector that started with the vcfocused silicon valley bank svb and continued with the cryptofocused signature bank it is possible that expanded trouble in the banking sector could finally win the rest of the battle that interest rate hikes have been fighting by “more decisively affecting aggregate demand” the banking sector simply isn’t particularly weak the collapse of two us banks doesn’t mean that many others are in trouble it means that two banks did a poor job of diversifying their exposures and managing their concentration risks the systemic risk posed by the svbsignature dual failure is in the same league as the systemic risk posed by the failure of longterm capital management back in 1998 sizeable enough to prompt a bailout but not sizeable enough to significantly affect the economy the credit suisse cs problem is very important for switzerland but that doesn’t mean it’s important for the united states the fact is that credit suisse has been helping clients—including americans—evade us and international banking regulations for many years that basic approach after all describes much of swiss history and much of the source of the country’s wealth the question was always whether the conflict between cs’s desire to make money and governments’ desire to enforce laws would tear the institution apart but the fact that the struggle was so pitched certainly made it difficult for cs to be more successful in the us market—which thankfully limits its systemic risk to the us economy despite its size there is still time for the svb signature and cs problems to ripple through the rest of the economy so far though it seems more likely that the banking system will rise up to the challenge if the fomc continues to raise interest rates that will increase the difficulty that borrowers already face in finding debt and equity capital at good terms if the fomc stops raising rates though that will be only because economic growth is definitely softening andor the banking system is under stress—which again will increase difficulty in finding capital the capital situation is already playing out with some investment managers for example andria cheng of costar in a recent article about blackstone putting a 270 million floatingrate loan into special servicing said “blackstone doesn’t believe it’s the best use of its capital at this time to fund cash flow shortfalls at these properties” in manhattan partly because they “have had higherthanexpected capital spending” four weeks later blackstone put a different 325 million into special servicing too—this one backed by properties in las vegas there is likely to be additional pain among real estate investment managers—whether interest rates continue to increase or whether they merely stay at something close to their current levels as with the banking sector though “pain” doesn’t mean “crisis” shocking failure to manage risk made svb inherently risky overexposure to a silly “asset” made signature inherently risky stubborn resistance to laws made credit suisse inherently risky—but most banks in the us and in europe have been managed more carefully in real estate the office sector is inherently risky partly because many investors and investment managers seem persistently to underestimate the capital expenditures required to maintain a competitive position in the office market also in real estate depending on floatingrate loans without hedging the risk of interestrate increases—during a period of years in which the fed made it clear rates could not stay low forever—is inherently risky but pain among holders of office properties among floatingrate borrowers or among managers who failed to properly underwrite capex requirements does not translate to a real estate crisis what it translates to is simply what warren buffett is credit with pointing out “only when the tide goes out do you learn who has been swimming naked”