The US Fed will negatively impact investment in Energy projects

The US Federal Reserve is really making history. Over the last decades we have not seen interest rates being adjusted up as much as what we saw in 2022. The aim was to control inflation, ok, and if you add mid-term elections (November 2022) to the recipe, then the decisions got trickier, we understand. But, what has happened to interest rates over the last 12 months should concern many financial institutions, as well as capital investment managers. Let's explain.

For one, there is no precedent for interest rate increases of such size in such a short time. In 2022 the US Fed increased interest rates seven times, some of them by 0.50 or 0.75 points, adding up to a total rate increase of 4.25% last year. Plus the most recent increase in 2023, the total adjustment is a jaw-dropping 4.50% increase in 11 months!. Never the brakes have been hit so hard in the US economy over the last decades:

·        In 2005, in a context of recovery after the 9-11 attacks, the Fed adjusted its rates eight times, but all adjustments were always of 0.25 point each time, so the total 2005 interest rate increase was just 2.0%

·        In 2001 we saw 11 downward adjustments by the Fed, totaling a decrease of 4.25% in the year (not an increase), in the context of the dot.com collapse, followed by the Enron debacle and the 9/11 attacks

But besides not being historical precedents to what has happened to interest rates so far, all of these comparisons are meaningless without analyzing the overall effect of such rate increases. By December 2022 the US economy was finally able to report that inflation had slowed, and even though last week's inflation report was "not as expected", it proves that interest rate changes are working.

But the economy does not work in a linear way though. Any interest rate adjustment will always take between 9 to 12 months to be able to "do" something to the economy, either help control inflation, or any other planned or unplanned impact.

In other words, the reductions we started to see in last December's inflation are most likely due to the result of the March and May 2022 rate changes, NOT by the overall 2022-2023 adjustments.

·        This means that, the overall 4.50% interest rate increases implemented over the last year will continue to impact the economy this year, in a way that nobody in the Fed has predicted nor warned. This months' increase could trickle down toward Main Street's economy by September 2023-January 2024.

Ok Jaime, but what exactly are you saying then?, are you forecasting an hard-landing, a recession?. Not necessarily. And this is not a critic to the Fed, by the way. They have a daunting task and are doing their best. The current economy has shown several strengths and increasing rates will not necessarily mean an overall recession. In fact, when the "recession" drums were making its noise prior to the Mid-term election, I always said that message was mainly political (those who saw my presentations at that time will remember my position).

What I am saying is simply that, the US Federal Reserve should take its time to wait and see, at the very least for 3-6 months how the inflation changes this year, before continuing with its frenzy of increasing rates and reacting to every inflation report, as if it was trying to stop a mini cooper. The Fed is trying to stop a fast-moving transatlantic, which takes time and more visibility to make further decisions.

What is most important to mention though at this moment, is that, if the Fed continues to increase rates over the next few months, it could impact the economy in such a way that, by early 2024 it could show signs of a slowdown that will not bode well in the run up to the Presidential elections. And then, the Fed could be faced with the hard decision to start decreasing rates, in order to incentivize economic growth prior to November 2024...

Independently of these economic and political decisions, the impact for this year will be important for the overall energy supply chain, with investments (i.e. renewables) in danger of being delayed due to elevated interest rates or lack of funding, while discretionary spending is reduced, likely impacting fuel demand in the US and increasing house-hold credit card debt, which could trigger financial jitters in the medium term. Way too much to talk about in so little space, so feel free to contact me in case you hade questions on these thoughts.

Jaime Brito

Consultant