Fed dealing with ‘one of the toughest acts they’ve ever had’ amid inflation, bank crisis: Strategist

RiverFront Investment Group Chief Investment Strategist Chris Konstantinos joins Yahoo Finance Live to discuss U.S. banking failures, credit creation, and the outlook for the Fed ahead of Wednesday’s FOMC meeting.

Video Transcript

RACHELLE AKUFFO: Time now for our chart of the day. A Bank of America fund managers survey shows that in addition to credit risks, investors are growing concerned about the economy. Recession fears ticked up in March, showing sentiment on the likelihood of a recession is rising again for the first time since November. Bank of America's survey shows a net 42% of participants expect a slowdown over the next 12 months. Meanwhile, expectations for stagflation have remained above 80% for 10 months in a row.

Well, coordinated intervention may have limited contagion risks in the banking system. Still, the noise surrounding what lies ahead for the Fed rate hikes remains unclear ahead of this week's FOMC meeting. Here to discuss is Chris Konstantinos, RiverFront Investment Group chief investment strategist. Good to see you here.

And so this is a tough meeting that the Fed was coming into. Obviously a lot of unexpected events over the course of the last week and a half. And part of that, though, meant that, in bailing out some of the banks, the Fed had to add $300 billion to its balance sheet. What kind of position is the Fed in going into this meeting?

CHRIS KONSTANTINOS: Well, first of all, thank you for having me. And I think even in normal times, I don't envy the job that the Fed has to do, you know, balancing keeping inflation contained and protecting jobs. But right now, I think this is one of the toughest acts that they've ever had, at least as long as I've been watching the Fed, which has been for a while.

Now they've got to figure out how to not just keep inflation contained but they actually have to figure out how to get inflation a lot lower, at the same time protecting jobs in the economy and now protecting the banking system as well. So I think it's a real tap dance here, and I don't think that I've ever seen the fed funds future curve or the probabilities change as dramatically in the quiet period before the Fed speaks as I have this past time.

So I don't envy Jay Powell and company. I think they have a really tough job to do. I expect that they are going to continue to hike tomorrow, but I think probably 25 basis points, and then I think there's going to be, like I mentioned, a real tap-dancing session trying to balance out all of the risks in the Q&A.

RACHELLE AKUFFO: And you can really tell that this has thrown a real spanner in the works because in terms of predictions, I mean, obviously about two weeks ago 50 basis points is probably what people were looking at, and then that sort of tapered down to 25. But now you're saying some people are saying that the Fed should pause rate hikes, should do the 25 basis points, should cut even by, in some instances, some suggesting a 50-point-basis hike. What are some of the scenarios if we do end up with just a pause versus 25 or a 50 rate cut?

CHRIS KONSTANTINOS: Sure. Let me lay out what I think is why some of those folks, very smart people, who are saying the Fed should pause or even cut. I think the logic behind that is related to the fact that with this banking crisis, the smaller-sized lenders that are really at the epicenter of this crisis are kind of the lifeblood of small-business lending, commercial-real-estate lending, et cetera, et cetera in America. And I've seen some studies that suggest that the sort of early run that we've seen on some of these banks is the equivalent of tightening financial conditions somewhere between 25 basis-- 25 and 50 basis points. So I think that's the logic.

Let me tell you, though, why I think that I disagree with that take a little bit. If you look at inflation trends-- and we like to dice them up between what we call sticky CPI and flexible CPI. As the name suggests, sticky CPI are the types of elements of that CPI basket that don't change a lot month over month. They're not that volatile, but they're really, really important parts of the consumer spending baskets. It's like 70% of the CPI basket's in what we call sticky. If you watch sticky CPI, it hasn't come down at all recently. And I think that's got to be on the Fed's radar screen as a potential concern.

So on one hand, they don't want to break the financial system. They want to protect jobs. But on the other hand, they're watching sticky CPI, core CPI not really do the dance that they want it to do. And so therefore I think they have to remain somewhat resolute in terms of interest-rate hiking here.

RACHELLE AKUFFO: And as they do keep sort of one eye on what's happening with some of this banking fallout, now you say that you don't expect the sort of magnitude of a fallout that we saw from 2008, whether it's in terms of the magnitude of it or the economic fallout. What are your expectations then for how this plays out since this does seem to be living with us for a while?

CHRIS KONSTANTINOS: Sure. So first of all, my backdrop for saying that is the fact that, as I look at what I'm calling the bank panic of '23, the bank panic of '23 so far is not a credit crisis. 2008 was very much a credit crisis. There was a ton of really ill-advised loans, mostly related to mortgages, real estate, et cetera, that were hiding on bank and shadow-bank balance sheets that all failed spectacularly.

Thus far in 2023, I don't see this as a credit crisis. I see it as an interest-rate-volatility crisis. Your guest a few minutes ago, the professor from Columbia Business School, I thought had some excellent points in his research on this. The idea is that the massive amount of interest-rate volatility, unexpected rising of interest rates, has caused a short-term illiquidity issue with a lot of smaller banks who didn't do a good job of interest-rate hedging, and you had a lot of uninsured deposits.

That is, at its core, a different type of crisis than a credit crisis, and I think it's one that's actually, on some level, easier for the Fed and for policymakers to help bolster because all they have to do is say, well, you've got all of these government securities that if you held them to maturity, theoretically they're money good. But because you have this run on your deposits, you can't do that. We're going to step in, and we're going to help you take those assets off your balance sheet, off the bank balance sheet, and onto to the Fed and the Treasury, FDIC, et cetera. That, in my mind, is a more manageable crisis for policymakers to handle.

Having said all that, though, we have to recognize what this is going to do to credit creation in these smaller institutions. It's going to grind it to a halt. And in doing so, that's going to have a chilling effect on the US economy, which is already in some sectors struggling. So I think that we have to be cognizant of the fact that economic growth is going to be lower here than it would have otherwise been prior to this mini crisis, and we have to factor that into, you know, our assumptions of what the future looks like.

RACHELLE AKUFFO: So, Chris, what does this mean for the Fed really walking this line then between sort of helping to create some of this volatility while also trying to create stability at the same time?

CHRIS KONSTANTINOS: Yes, I think it means that, on some level, I think that the modern Fed has always-- they've tried to be as transparent as possible. But sometimes forward guidance is not a good thing when the backdrop is so uncertain, right, just like we just we talked about a few minutes ago with how much expectations changed during the Fed's quiet window. I think the Fed is going to have to be really careful about forward guidance here and potentially not give a whole lot of it because, you know, they're not omnipotent. They don't know what's coming down the pike, and I think they want to keep their options open. So I think they're going to have to be very, very careful about what types of information they're going to give to the marketplace.

I also think that they have to strike this balance of making sure that the public understands that the government is on the case as it relates to these bank runs and that they're not going to allow them to seep deeply into the, you know, globally systemically important banking system where the majority of deposits now are. But at the same time, they have to convince the market that they're not, you know, giving up the inflation fight.

I actually-- my personal view is if they halted interest-rate hikes at this week's meeting, I actually think that risk assets might rally at first but then might actually panic because now they'd be saying, well, what does the Fed know that we don't if they're going as far as to give up their fight on inflation here? So I actually think that they have to strike a balance. I think if their message is too far towards price stability or too much towards financial stability or inflation stability, too much in either direction I think is going to be tough for the market to take. So I think they have to be very, very balanced in their statements.

RACHELLE AKUFFO: I certainly wouldn't want to be Jay Powell in this situation. I'm sure every word will be being parsed through.

Chris Konstantinos, thank you so much, RiverFront Investment Group chief investment strategist. Thank you for your time this morning.