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Fed rate hikes: ‘This is a pretty tough episode that we’re going through,’ economist says

Citi Chief Global Economist Nathan Sheets joins Yahoo Finance Live to discuss the prospect for further rate hikes, the U.S. banking system, investor concerns, and the outlook for inflation.

Video transcript

- And while US officials continue to tackle inflation, the downside risks around the Fed's forecast becomes potentially more acute. So here to discuss is Nathan Sheets, Citi chief global economist here. And, Nathan, over the past couple of weeks, especially this week, considering some of the either firesale buyouts and acquisitions that have had to take place or even the cash injections that have needed to be put forth, where do you see this all netting out? And is this a crisis, as some have called it? Or is this just something that is typical of the banks, given a volatile environment like this?

NATHAN SHEETS: I think the only good news I have is this is not 2008. The banks are better capitalized. The regulation is better. I think risk throughout the system is valued more appropriately.

But this is a pretty tough episode that we're going through. At a minimum, we could call it banking sector or financial sector stresses, whether, as you ask, whether it rises to the full term yet, being a crisis, I think, is an open issue. But this is a tough time. And there are some meaningful stresses in the banking system as banks' balance sheets adjust to the realities of this is a higher-rate environment. And as the Fed continues to hike rates and the ECB continues to hike rates to fight inflation, this is a tough episode for markets, for policymakers and for the economy.

- And it is. And I'm looking at your projections for the Fed's terminal rate. And you expect another 3/4 point rate hike, taking the range from 5 and 1/2% to 5.75%. That, I would say, is above the consensus here, a little bit hot.

But how do you square that, too, with the rate cuts that have been aggressively priced in in coming quarters? I remember a year ago, people were pricing in rate cuts as soon as right now. Obviously, that's not happening. We're still raising.

So just wondering how those two dynamics are playing out. You're thinking the Fed is going to raise rates another 3/4 points. And then what do you think about those rate cuts that are priced in?

NATHAN SHEETS: Well, our baseline expectation is that these financial stresses largely abate over the next six to eight weeks. It's going to be bumpy. It's going to be uneven. There could be some more pressures and challenges along the way, but that they largely dissipate.

And as that happens, the Fed is still left with the reality of a tight labor market and rising services inflation. Now, that is going to require more Fed rate hikes. And, ultimately, they'll need to take the Fed funds rate into the mid 5% range.

But that's our baseline. But we're sweating bullets around it, to say the least. It would probably put a 2/3 probability on the baseline. There's a third of the probability mass on weaker outcomes, which would involve rate cuts of various stripes and varieties. But, bottom line, if things go as we expect, it's going to be mainly about inflation. We are worried, deeply profoundly worried about downside risks that would require more aggressive policy from the Fed, not only liquidity front, but also on a rate cuts front as well.

- Look, Nathan, you're not lying. I think all of us need stronger antiperspirant after what we've been watching within the banking sector over the past couple of weeks here because we're sweating hard. At the end of the day, I think I'm going to need to answer to my mother, my family about what's taking place right now.

And even within the base-case scenario that you've laid out-- and I can go back and play a clip for them-- what do I tell them? What do you tell the average person who is looking at this right now or the investor that's trying to position their portfolio to say, don't be concerned unless you see this? What is that this that you would be looking at?

NATHAN SHEETS: I think that if we see a further proliferation of banking sector stresses, either into the smaller banks or into the larger banks, I think that that would be, for me, really an indication that there is a deeper risk here in the United States. So far, the stresses have been concentrated in the medium-sized banks, banks with assets of roughly $100 to $250 billion. And that is the group of banks where Congress and the Fed in 2018 made a decision to reduce the vigor of regulation. And that is where the problems are arising. But if we start to see a further proliferation into banks of other sizes, larger or smaller, I think that would mean that we need to revise our narrative on what's happening.

More fundamentally, I think the issue here is the banks are adjusting to the reality of higher rates. And that's true in terms of the implications for the asset side. Its true implications for deposits and what they need to pay on the liability side. And, also, it's true for bank margins, which are currently under pressure because they have to pay more on deposits.

- Well, that was my next question there because there's a huge mismatch between what banks are paying on the deposit side and what investors can get on the money market side. And I have a chart here on the YFi Interactive. This is the assets in money market funds. And this goes back to mid 2020.

But the acceleration that we're looking at here started when the Fed started really aggressively increasing its rates. What's taking banks so long to adjust to this reality? If banks want to stem this outflow, they have to reduce their profitability. Is there some other hat trick that the Fed or regulators can pull that would somehow stem the tide here?

NATHAN SHEETS: The Fed has created facilities that give the banks plenty of liquidity to be able to meet any conceivable outflow. And we are seeing banks borrow at the Fed's discount window and at various other facilities that the Fed has created so that they can meet that outflow.

But I think, ultimately, it's about the stickiness of deposits. The many particularly retail deposits are unlikely to move to money market mutual funds. And operational deposits may not move because it's challenging. And you rely on your bank to for transaction services.

But the extent of the outflow and the reality that you can make more in a money market mutual fund is a challenge that the banks have to respond to. And it is going to continue to require them to increase what they're paying on deposits. And how much they'll need to raise that deposit rate, I think, is an open issue. But it has huge implications for their profitability going forward. And I think that over the medium term, just how damaged the bank's business models are, just how challenged or maybe even underwater the margins are for a while is the key question that people are thinking about in terms of the sustainability of some of these financial institutions.

- And mobile banking, people just press that button, they got their password set now, they can move that money in an instant. So we'll see if that stickiness remains here. Thank you, Citi Chief Global Economist Nathan Sheet.