I read through the Fed’s 2022 bank “stress test” over lunch. It is almost comical how the Fed did not flex interest rates by more than 150 BPS in its Baseline and Severely Adverse scenarios. There really is no logical reason for not running various modeling scenarios that would see rates climb by 1,000 BPS in 25 BPS increments. The Fed Funds Rate has overshot the Fed’s short-term rate scenarios by almost 400 BPS. Just another example of the Fed’s wishful thinking. The Central Bank ought to have a singular mandate of a strong U.S. Dollar. This would put the Fed in natural conflict with Quantitative Easing and subsidizing Fiscal spending. However, in practice the Fed is an appendage of Treasury, all to ready to facilitate Fiscal spending and cover Fiscal deficits rather than stem the bleeding.
The baseline scenario for the United States is an economic expansion over the 13-quarter scenario period. The unemployment rate declines gradually from close to 4-1/4 percent at the end of 2021 to about 3-1/2 percent by the end of the scenario. Real GDP growth declines from about 6 percent at the end of 2021 to around 2 percent at the end of the scenario. CPI inflation also declines from around 8-1/4 percent at the end of 2021 to about 2-1/4 percent by the end of the scenario. The scenario includes increases in interest rates. The 3-month Treasury rate increases from around 0 percent to about 1-1/2 percent at the end of the scenario. Ten-year Treasury yields increase from around 1-1/2 percent to around 2-1/2 percent at the end of the scenario. The prime rate increases in line with short-term interest rates, whereas yields on BBB-rated corporate bonds and mortgage rates increase in line with long-term interest rates.
Severely Adverse Scenario
Consistent with the Scenario Design Framework, under the severely adverse scenario the U.S. unemployment rate climbs to a peak of 10 percent in the third quarter of 2023 (see table 3.A), a 5-3/4 percentage point increase relative to its fourth-quarter 2021 level. This year’s scenario features a sharp decline in real GDP in 2022 followed by a robust recovery. Real GDP declines more than 3-1/2 percent from the fourth quarter of 2021 to its trough in the first quarter of 2023. The rising unemployment and the rapid decline in aggregate demand for goods and services lead to significantly reduced inflationary pressures. CPI inflation falls from an annual rate of 8-1/4 percent at the end of 2021 to an annual rate of about 1-1/4 percent in the third quarter of 2022 and then gradually increases above 1-1/2 percent by the end of the scenario.
Short-term interest rates as measured by the 3-month Treasury rate remain near zero throughout the scenario. Long-term interest rates as measured by the 10-year Treasury yield drop to 3/4 percent during the first quarter of 2022 and remain unchanged in the second and third quarters of 2022, after which they gradually rise to 1-1/2 percent by the end of the scenario. Because short-term interest rates remain near zero, the path of the yield curve slope, as defined by the difference between the 10-year Treasury yield and the 3-month Treasury rate, follows that of long-term interest rates.
Conditions in corporate bond markets deteriorate markedly. The spread between yields on investment-grade corporate bonds and yields on 10-year Treasury securities widens to 5-3/4 percentage points by mid–2022, an increase of close to 4-3/4 percentage points relative to the fourth quarter of 2021. Corporate bond spreads then gradually decline to 2-1/4 percentage points by the end of the scenario. The spread between mortgage rates and 10-year Treasury yields widens to 3 percentage points by mid–2022 before declining to slightly above 1-1/2 percentage points at the end of the scenario.
Read the Fed’s stress test in full here: https://www.federalreserve.gov/publications/2022-Stress-Test-Scenarios.htm