Former Fed President: Oil Shock Could Trigger Financial Instability | Thomas Hoenig
Summary
Market Outlook: The Fed faces rising uncertainty from weak GDP, oil-driven inflation pressure, and slowing growth, increasing the risk of stagflation.
Energy Impact: An oil shock is expected to pressure consumers and the economy, echoing 1970s dynamics and complicating Fed rate decisions.
Treasury Market: Persistent ~$2T annual deficits are straining reserves, prompting QE-like liquidity (~$40B/month) focused on the short end to stabilize funding and prevent rate spikes.
Banking Stress: Diversified banks face stock pressure and rising uncertainty, with capital adequacy and recent capital-rule easing flagged as key stability risks.
Private Credit Stress: Higher rates and reduced liquidity expose weaker loans, risking a domino effect from private credit losses to banks that finance them.
Policy and Politics: Political pressure for cuts collides with fiscal dominance; credibility and a Treasury-Fed accord are critical to anchor inflation expectations.
Fed Strategy: The guest favors patience and intermeeting flexibility, warning against panic QE or premature cuts that could reignite inflation.
Transcript
We are about a week away from the next Fed meeting and we need to understand what is happening in the background and we need to make sense of some of the trends we've been witnessing here over the last few months. Just this morning as we're recording this here on March the 13th. It's Friday the 13th. I haven't realized until I said it out loud, but it's Friday the 13th as well and we got some very negative GDP numbers. And uh another economic factor of course is the oil price. How is it impacting the American consumer and how is the Fed taking the oil price and gas price shock into consideration when look talking about the Fed funds rate? Of course, I've invited back a phenomenal guest. He's the former Fed president or Fed chair uh of the Kansas City Fed and I'm really looking forward to catching up with Thomas Hernick. But before I switch over to my guest, hit that like and subscribe button. It helps us out tremendously and we really appreciate it. Now Thomas, it's a great pleasure to welcome you back on Soore Financially. Thank you so much for joining us again. Well, thank you first of all and uh it's good to join you again and I look forward to the conversation. >> Yeah, likewise. Likewise. We have lots to discuss, lots going on. Uh we put the Fed a little bit on the back burner here the last 10 days for obvious reason and uh but it's now time to talk about the Fed again and the decision-m process and what is going into the decision of course here at the Fed. But but let let's start high level Thomas. Um last time we spoke you said three things that really really stuck with me. One is that the the Fed has a structural bias towards easing. Um the Fed has an implied mandate to stabilize the Treasury market. I think we can all agree on that. And uh in a real crisis, you said the Fed would step in again. What has changed since we spoke about 8 nine months ago? Has anything changed? >> Well, I think if anything, it's become more apparent that these um these observations I think are valid, continue to be valid. I think they will come to be tested here in the next uh few weeks. Um maybe even as soon as next week when the FOMC meets. We'll have to wait and see, I think. But uh I and I think the economy is actually going to be under perhaps not not only actually but obviously is going to be under enormous pressure and the Fed will therefore be under enormous pressure to try and um compensate for the um for the price increases we're going to see around energy uh and the slowdown in the economy that we will see see with that. Uh so there'll be a lot of of pressure on the Fed to help out in the sense of stimulating the economy through monetary policy and it will be very difficult for the Fed to resist that. Although in part um they should help where they can but not get so involved that they reignite inflation uh three four weeks from now or a month from now or half a year from now given any enormous knee-jerk reaction uh in the sense of pumping extremely more money into the economy. And I think that's very important to keep in mind uh as you think about how the Fed's going to discuss this next week. Yeah, lot lots of factors going into that of course and we'll we'll get more granular here in a second just talking about the oil price in particular, but what has you worried the most right now? Is it inflation? Is it recession fears perhaps or just financial stability in general? >> Well, my greatest fear is that there'll be financial stability issues. Um, when you have a crisis like this and you have this oil shock, it's going to put a lot of downward pressure on the economy. it's going to slow the economy if it if it goes on too long or even very long and and therefore I don't think inflation will be the immediate problem. I think the uh pressures on the financial market, pressures on the real economy will slow this economy and that I think is a is a major concern uh and should be a major concern of both the administration, Congress and of course the Fed. Has the market understood that risk yet to financial stability? Is that priced in? I I keep hearing also from friends that risks are not properly priced in yet. What what is your opinion on that? >> Well, I think risks have not been properly priced. I beca I think they're becoming more so. If you look at the the pressure on the commercial banking, the largest commercial banking industry, you're seeing their their stock uh suffer uh if you will because of the uncertainties around uh all these events and and around the credit they have on their books. I mean, there's a whole array of conversations now about private credit in these banks. U banks have been lending to them. That's got people on edge uh in the market. So, I think I'm more concerned about economic and financial stability right now than I am inflation. uh although inflation will spike uh given the oil uh and that you know that combination uh I think they used to call stagflation is um more a possibility now than it was just a few weeks ago. >> Absolutely. Yeah. The the capital swword uh that Jerome Powell doesn't like to say out loud, but uh >> he he's been dancing around that word quite a few times in recent press conferences. Yes, he has. >> Um it has been interesting to observe and I'm really looking >> it's going to be harder for him to dance around it now because this is a perfect example uh of what happened in the 70s and I think um that was a period of stagflation and it was oil price shocks and a slowing economy. Uh and we have that combination at least in train now uh depending on how long this war goes. >> Well, exactly. So the question is what did the Fed do back in the 70s? Can we learn from what they did back then? Was it a mistake? Did they do the right thing? And uh what what should the Fed now do? >> Well, you know, the I think it'll be a tough decision. Um I think that if they obviously raise rates because they have inflation, that would be a mistake if it's oil caused. But also the problem is if they lower rates trying to offset the effects of the shock that will u that will put inflation more in train as well. So they're really in a difficult position and I think that'll be part of the discussion next week and that is do they hold steady and let this uh both the war the oil shock and the economy uh give them more signals going forward uh or do they try and anticipate that and I think their best course of action is to to wait carefully and let things work through a little bit. Now you can, you know, if things get worse, you can have interme uh inter period meetings uh among the FOMC. So it's not as if they make that decision, they can't change it. So they ought to they ought to try and watch and see. I think that would be the more prudent action on their part. Uh I would also point out that I think part of the reason they can be careful now is that when you look at where interest rates are 3 and a half% uh and inflation between 2 and a half and 3% real rates that's what really drives the economy in a sense are are closer to 1%. And that's that's not too far off the mark on equilibrium. think and many many think that uh the equilibrium rate is closer to say um more than 1%. So I think those are important things to keep in mind and I think there are things that the FOMC will have in mind as well. >> Absolutely. We just got some uh GDP data this morning as well or an update on the US GDP data and it's much weaker in Q4 than a lot of people have thought although we've been discussing this on our channel that the the real economy is much weaker than the numbers might suggest. Now we got a print of.7% in Q4 2025 revised down by 50% from 1.4% down to 7 which is a sharp drop from Q3 which was over 4% in Q3. Um how do you see the economy developing? Let's stay on the macro side for one second before we get more granular again. >> Well, the economy, you know, with the fourth quarter number was a disappointing number for everyone. I realize uh and I think uh there's a couple things you got to keep in mind. Starting at the first of the year, there were many tax um favorable uh actions take took effect in the first of the year. uh exemptions for tips, exemptions for overtime, um deductions on car purchases, uh some some a greater improvement in in the tax refunds uh given the the extension of some of the uh uh earlier tax benefits. So, those are those are stimulative effects that will take place in the first quarter. uh but I don't know that there will be enough depending on how uh the current economy uh uh is subject to oil price shocks to some concern about the condition of the banking industry and the private credit industry. uh all those uncertainties uh and then the uncertainty of the war. I think those are the negative factors that offset those beneficial tax uh actions that that are taking effect in the first quarter. So on balance I think it's it's more negative for the economy in the first quarter and beyond uh subject to uh changing circumstances internationally and no one I can't predict that no one can and I don't think the FOMC can and that's why I think being careful and holding carefully uh will uh uh be very important. Now, I do think that you'll see in the media and everywhere else that the prospects for a cut uh either sooner in 2026 or more cuts in 2026 will become a much more common topic. Uh as people anticipate a slowing economy, they would expect the Fed to ease and so would I. >> We're 99% for no cut right now. That's what Fed watch tells us or the CME Fedatch tool. Um, I think we I'm curious though, like I'm not I wouldn't rule anything out anymore for Wednesday personally, like given just the data we've been seeing and just what we're seeing of course in the Middle East and in general. So, I'm I'm not so sure why the market is so fixated on no cut right now. So, like I have my doubts. >> It's it's hard to know and that the the difficulty in any of that is the the uncertainty factor has just risen enormously. And when there's great uncertainty, people tend to pause and and and wait and hesitate. And that's true for the real economy. That's true for the financial economy. And we'll see how it affects the Fed because if that's the case and they see this slowing, they they may put they may find themselves saying, "Well, maybe we ought to cut." And that I think something they ought to be very careful about. >> It reminds me a bit of a deer in the headlights, of course, being caught between all that data and all of a sudden the lights are light the light is on them. How do you think like you're an insider of course at the Fed that's why I'm asking this but like how do you sort of avoid that and I'm not sure inertia is the right word but just like stoism just like when when you can't move like when you're stuck like I'm looking for that one specific word here mentally but when when you're stuck like how do you get out of that rut perhaps? >> Well I don't think that they're like deer in a headlight. I mean they they they can see what's coming uh and they can in fact uh you know is it is it is it real or is it not and they can make a judgment. Uh and so if if they think well wait a minute we're trading off here inflation, you know, we need to we need to wait. We need to let this fall through because if we move too soon, uh we're going to have a worse inflation environment. If and we know if we wait too long, we could have a um a a crisis on our hands. Uh so they're going to be they're aware of those choices. And that's why I emphasized to you earlier, they don't have to wait to the next meeting to take action. It's not like they can't move uh once they have more information and I think that may be how the conversation goes um at the at the meeting. >> No, no, fair fair enough. And I appreciate you clarifying that because uh the question is is it a train or is just a guy with a with a flashlight that's coming towards you? Right. So, >> right. Got to wait. Let's let's get a little bit of picture of what is coming at us. >> Exactly. Right. And and that's what we're trying to all of us are trying to figure out cuz we don't even know the length of what is happening in the Middle East. If it's done tomorrow, fantastic. But I think experts are predicting this might be drawn out. So which could be causing more chaos in the economy or global economy for that for that matter. >> That's a risk. That's a real risk. >> Absolutely. >> Um Thomas, you mentioned as well that the Treasury market is sort of the third mandate of the Fed. Uh we we talked about inflation already here, but third mandate is really the Treasury market. It has been interesting to to watch the 10-year yield uh move around. Uh it it rallied or the 10-year bond rallied and now it's being sold off again. Um sure. >> How do you put that into perspective for the Fed? Like how are they sort of following that because there's a there's a cap of course and they have stepped into the Treasury market on the short end recently as well. So how is the Fed dealing with the Treasury market right now Thomas? >> Well I think first of all they are beginning to focus on the short end because that's where they belong. they shouldn't be managing the yield curve. They know that and they would like I think they would like to get away from doing that. Um and that means the 10year and the longer side would the market would be more involved in determining that than the Fed. Now having said that the other issue that the Fed is confronting and that is that our national debt continues to rise at a clip of about two trillion a year. Um and you know that's pretty significant. And what that means is demand for reserves because someone's got to fund this debt is uh shifting. Uh and that puts upward pressure on interest rates. And I think that's why in part you see the the uh the Fed re-engaging in what you and I call quantitative easing as as of December. uh because they have to provide the reserves uh that facilitate the funding of that debt through the market uh by by allowing the market to have these reserves to buy to buy more government securities. So that's that's really a part that's entering this picture of uncertainty their need to help the government fund its debt or failing to do that interest rates will rise uh on their own. Uh and uh if you go back to December in the fall, the so-called u uh overnight funding rate um secured overnight funding rate was rising above the target Fed funds rate and the secured overnight funding rate is a less risky uh interest rate pricing on less risky asset that is secured uh securities and so um or secured borrowing. So what you had then was that was a sign that the market liquidity the availability of reserves to help fund this uh deficit was getting strained and the Fed stepped in to provide more liquidity into the market. So that's you know that process is also taking place right now. The debt has to be auctioned the Fed has to get it marketked. uh that puts upward pressure on interest rates and that's why you see the Fed uh putting $40 billion a month uh of purchasing of that government of government securities to free up some of the reserves for those purchases. So it gets very complicated. Now we have another factor uh influencing the Fed's policy choices. Uh just just to clarify also for myself, the the QE or nonQE QE that they've announced last year that is being executed right now, the 40 billion that you referenced, is that really just to buy on the short end or is that completely separate? Just just to clarify here. >> Well, I I don't know the answer to that, but I I think I think it's mostly on the short end. I've I've been I follow the the balance sheet. Now, one of their one of their other uh nuances of all this is that they're allowing the mortgage back securities, the that credit, which the housing market credit to run off. And then I I think part to to keep the 10-year from I guess becoming more volatile, they may be injecting uh funds in the 10 year to try and make sure that part of the yield curve doesn't become too uh too unstable. >> It brings me back to the the Fed put and uh is the market is the market expecting to be bailed out again in by the Fed for example as well. I think that's what the Fed put means here. um if QE is is maybe the first step in that direction. Um do you think the Fed will continue expanding its balance sheet and how will that show up and how will we notice that? >> Well um that is that is really a an important question. When the Fed announced its 40 billion it said it was temporary. I think they said you know through this tax season through the refunds. Uh but I I I remind people that the original QE was temporary. Uh so temporary by one's definition may be something different by another definition. I suspect given the pressure that the markets will face and that that will be there with this increased funding for the $2 trillion deficit that may grow with this war that the Fed will be under enormous pressure to help fund to re to keep the the the liquidity in the market uh in place. I think they'll be uh under pressure to to extend this this uh this $40 billion a month well into the rest of the year. That's that's a judgment on my part. Uh they could they could lower it sooner. That is reduce it from 40 to some much smaller number. I don't expect that to be honest with you right now. >> It's it's a good segue to discuss perhaps the new Fed chair that has been announced as well. He hasn't been confirmed yet, but because we need to talk about the Fed put always comes uh comes up in in conversation when the when we talk about maybe the S&P or the NASDAQ dropping massively and then the Fed could jump in and maybe ease monetary restrictions or just pump more money into the market quite literally to stabilize things. Kevin Walsh has been announced as a new Fed chair um by by President Trump. The question is why though? Um he's known as a hawk um or used to be known as a hawk. So, I'm curious, Thomas, um, any any insights on what he might have said during his job interview that he had convinced the president to announce him and why is he the right man for the job now? >> Well, I think u, first of all, I don't know. Let me let me clarify. Um, I'm like everyone else speculating, but I I I think part of what Kevin Walsh has said is that there ought to be a new Treasury Fed accord. And what that means is that the the Fed would be free to conduct monetary policy without the Treasury or the administration um getting in the way of that. But I think also what he's saying is uh what that did was it gave the market confidence that the Fed could do what is necessary uh to keep inflation under check. And when you give the market that kind of confidence, uh inflation expectations become more anchored. Uh there is less upward pressure on interest rates uh and you are able to then not have to raise interest rates or perhaps even lower interest rates. I would assume uh maybe incorrectly that that would be the the uh argument or the explanation that someone like Kevin Walsh would give. Now one of the difficulties about that is uh in the other instances in the past u even when there was a treasury court the actual deficit the increase in new debt every year was much smaller. Under current circumstances uh the the the debt is the deficit the new debt entering the economy each year is about 6% of our gross domestic product. In the 50s when the earlier accord was in place, it was closer to three or less percent of GDP. That's a lot less stress coming into the market to be funded. Uh and so that's going to be the challenge for whoever is the chairman and I suspect it will be uh Mr. Borch and uh that will be his challenge. How to convince the world that yes the Fed is going to make sure that inflation doesn't break out and therefore you can be confident of that. That is a very important part of his job going forward and that's going to be tough given the size of the new debt that has to be funded each quarter. >> Now it's political pressure is increasing of course on the Fed as well. President Trump just posted on on Truth Social again like we need to lower the interest rates tomorrow or actually immediately. I'm I'm paraphrasing. I don't know the exact quote of course. >> Um it's not getting easier for any Fed chair. Um or the Fed in general to to sort of navigate this market. Um how important is or what what's a bigger risk perhaps is the right question. Political pressure or fiscal dominance right now there Thomas? Well, they're they're two sides of the same coin. Um political pressure is going to be is enormous as you can see. Uh but so is fiscal dominance because um the the the debt has to be funded and um that means the the the that the foreign buyers and domestic buyers have to be willing to increase their holdings of of the national debt that insurance companies, pension funds, banks in the United States, foreign owners uh have to be willing to buy it. And is is the US debt uh something that more uh that people want to have more of? And that you don't know the answer to. But if they don't want to have more of it, that means pressure has to go on the Fed to pick up the excess supply of treasuries uh in the form of demand in the in uh to to increase reserves to allow that. And that's where they get involved in in basically monetizing more of the debt. And that that's the fiscal dominance side. Uh the the economy, the political pressure, lower rates so we keep things going, risking higher inflation versus we have a we have to fund this debt no matter what. If you let uh don't if you don't accommodate it, interest rates go up, so you have to accommodate it. That's the other side. The same pressure on the Fed from both sides. The Fed's job is to say, well, wait a minute, Congress, you've got to watch the deficit. uh the the economy itself uh has to get through this crisis period of war uh and the and the deficit. Uh we can't solve all those problems and they have to be able to explain themselves very carefully in saying that and in saying no to both fiscal dominance and to the shortrun needs of of any administ of any political uh side of the argument. Yeah, it's closely linked political pressure and the fiscal dominance side. I would I would agree because uh one helps the other because the the political side wants lower interest rate at least uh the the head of the you know the constituency or not constituency, the head of the White House like the president of course, right? We we know who that is. Um >> absolutely. Thomas, one last topic I want to touch on with you real quick is the private credit market. Um it it seems like there's a lot of pressure or and stress coming from that direction. uh loans that were in perfect standing in perfect health three months ago are now being written off as zeros. Uh we're just saw that we just saw headlines I think it was Black Rockck or um that that announced that as well. It was only a small $24 million loan um which was used in the Financial Times as an example, but it it highlights that healthy is not healthy anymore and uh the private credit market seems to be breaking. Um a what is your assessment of the private credit market and b of course what can the Fed do to help stabilize that private credit market perhaps? Well, first of all, the private credit market is designed to accept more risk, more risk than the banks are willing or able to accept. Uh so they're making loans to a higher risk category of borrowers. Uh and they are um they were able to do that in an environment of very low interest rates u more easily because their cost of funds were less. they could they the access to funding was uh easier and that all these funds started up and they began to make these loans. Well, then the economy uh as as the Fed did QE Q excuse me QT uh since 2022 until this past fall uh the the excess liquidity in the market was being slowly drawn out as the de as it was being shifted to funding the US debt. That meant availability of these funds were less. Interest rate pressures began to rise uh in 22 and then the excess liquidity began to run out. So these these private credit uh also had to find more loans to make of quality and they become more scarce because interest rates are higher. So now they're under pressure. Um these companies, these high risk companies, these leverage companies are now uh showing their their uh stains. Uh and the markets picked up on that. I mean these small failures as as as you know are an early indicator. Uh they may be the so-called canary in the mine coal mine. Uh and they have begun to show it and people are saying well wait a minute I want to get out first. It's a typical kind of bank uncertainty run because they're not their funds are not insured. Uh they're there and so that's going on right now. Uh and so I think it it is a bit of a run based on uncertainty. uh and I think that is the first step. The second step is the commercial banks, the largest banks have um been lending to these private credit companies so that they could become more levered and therefore increase their returns uh to their u to their limited partners, their so-called uh investors. And they've done that fairly extensively on the assumption that well, you know, they're in a sense diversifying because they don't, you know, they don't have all these loans. They all they have is this one loan and they can't all go broke. So now though that as the number of bad loans mount in these private credit, that puts more pressure on the banks and so you get the domino effect coming and that's why you see bank stock prices under pressure. That's the economy. uh the the what I call the inner uh inter relationships within the credit markets showing their effects. And so I think we have a a period ahead that will be a lot of stress on those credit private credit and uh stress on the banks who have loaned to those private credit and we'll they'll work their way through that hopefully uh without major crisis uh that would cause the Fed to have to step in. >> How could the Fed stabilize though? just by lowering interest rates to make money easier and cheaper to to access perhaps. Is that the only way? >> Well, there's a couple things. One is if people lose begin to lose confidence in the in that financial part of that is the banks lending to them, the Fed can provide money liquidity to those banks and that helps them fund and therefore stabilizes the market and the interbank market. But that's a temporary fix. What really has to happen is that the we have to settle through these private credit have to get through their their losses, stabilize uh probably at a smaller there'll be a smaller size but stabilize and that allows the banks to stabilize and the Fed can provide liquidity during that process but it cannot provide capital. And so that brings us to the other point. Are the institutions sufficiently capitalized to withstand the downward pressure? And that's interesting because the Fed and the other agencies have eased the capital rules recently uh at the very time that the capital is going to come under pressure. But I hope uh and I'm use the word hope because I don't know that there is sufficient capital to say, "Oh yeah, we can absorb that. We'll get through this." Uh yes, would take some hits to our bank stock, but the capital's there. uh and that means that's the ingredient to sustainability and confidence and I hope the banks are able to show the world uh and I hope these private credit are able to show the world that they are well capitalized and that's a question mark I can't answer >> no fantastic Thomas that that was wonderful I have one last question for you maybe just a bit of a summary question as well is there anything that the Fed could do uh or what could be the biggest policy mistake the Fed could do here in the next 6 to 12 months Well, the biggest mistake would be to panic and start massive QE. Uh that would ignite the inflation later on. And the other is to say, wait a minute, we can do nothing. Uh they need to be very I mean they they need to work with the controller and the FDI. They need to know the condition of their banks. They need to make sure they're in strong position because the banks are critical to stability and uh getting through this this uncertain difficult time. >> No, fantastic. Thomas, tremendously appreciate your time and insights. >> Um can't wait to do this again soon. We got to do this more often. Every nine months takes too long. There's so much going on. Um fantastic insights. Uh Thomas, is there a way to follow more of your work? And uh I know you're distinguished senior fellow over the Macato Center. Um, where where can we follow your work? >> Well, uh, we're on Substack on Finn Red Drag. It's called Finn Ray Rag on Substack. And I I put pieces out there occasionally uh recently on the on the issue of the debt deficit and the and the Fed's funding. I've done some other work on the capital and the uncertainties around the the deregulation environment. So, people can read that uh online on Substack on Finn Red for the Micada Center. >> Fantastic. Thank you so much, Thomas. It was a great pleasure catching up. I hope you're having a good Friday the 13th and uh we'll talk very soon. Thank you so much. >> I hope I make it through. All right. >> H you'll be fine. You'll be fine. Superstition, right? >> Awesome. Thomas, thank you so much. And everybody else, thank you so much for tuning in here to Sore financially. What a wonderful discussion about the inner workings of the Fed. What are they taking into consideration and what should they be doing right now? Well, one thing they shouldn't be doing right now is panic, as Thomas said, and I think that's something we can all agree on. We got to be careful that inflation genie needs to stay in its bottle for a little bit longer before things can happen because the oil price will add enough pressure anyway. So, thanks so much for tuning in. If you haven't done so, hit that like and subscribe button. It helps us out tremendously bringing phenomenal guests like Thomas Hernick here onto the program and we just appreciate it as well. Take care out there. Don't let the emotions run high. Don't let emotions guide your investments. Thank you so much. Take care.
Former Fed President: Oil Shock Could Trigger Financial Instability | Thomas Hoenig
Summary
Transcript
We are about a week away from the next Fed meeting and we need to understand what is happening in the background and we need to make sense of some of the trends we've been witnessing here over the last few months. Just this morning as we're recording this here on March the 13th. It's Friday the 13th. I haven't realized until I said it out loud, but it's Friday the 13th as well and we got some very negative GDP numbers. And uh another economic factor of course is the oil price. How is it impacting the American consumer and how is the Fed taking the oil price and gas price shock into consideration when look talking about the Fed funds rate? Of course, I've invited back a phenomenal guest. He's the former Fed president or Fed chair uh of the Kansas City Fed and I'm really looking forward to catching up with Thomas Hernick. But before I switch over to my guest, hit that like and subscribe button. It helps us out tremendously and we really appreciate it. Now Thomas, it's a great pleasure to welcome you back on Soore Financially. Thank you so much for joining us again. Well, thank you first of all and uh it's good to join you again and I look forward to the conversation. >> Yeah, likewise. Likewise. We have lots to discuss, lots going on. Uh we put the Fed a little bit on the back burner here the last 10 days for obvious reason and uh but it's now time to talk about the Fed again and the decision-m process and what is going into the decision of course here at the Fed. But but let let's start high level Thomas. Um last time we spoke you said three things that really really stuck with me. One is that the the Fed has a structural bias towards easing. Um the Fed has an implied mandate to stabilize the Treasury market. I think we can all agree on that. And uh in a real crisis, you said the Fed would step in again. What has changed since we spoke about 8 nine months ago? Has anything changed? >> Well, I think if anything, it's become more apparent that these um these observations I think are valid, continue to be valid. I think they will come to be tested here in the next uh few weeks. Um maybe even as soon as next week when the FOMC meets. We'll have to wait and see, I think. But uh I and I think the economy is actually going to be under perhaps not not only actually but obviously is going to be under enormous pressure and the Fed will therefore be under enormous pressure to try and um compensate for the um for the price increases we're going to see around energy uh and the slowdown in the economy that we will see see with that. Uh so there'll be a lot of of pressure on the Fed to help out in the sense of stimulating the economy through monetary policy and it will be very difficult for the Fed to resist that. Although in part um they should help where they can but not get so involved that they reignite inflation uh three four weeks from now or a month from now or half a year from now given any enormous knee-jerk reaction uh in the sense of pumping extremely more money into the economy. And I think that's very important to keep in mind uh as you think about how the Fed's going to discuss this next week. Yeah, lot lots of factors going into that of course and we'll we'll get more granular here in a second just talking about the oil price in particular, but what has you worried the most right now? Is it inflation? Is it recession fears perhaps or just financial stability in general? >> Well, my greatest fear is that there'll be financial stability issues. Um, when you have a crisis like this and you have this oil shock, it's going to put a lot of downward pressure on the economy. it's going to slow the economy if it if it goes on too long or even very long and and therefore I don't think inflation will be the immediate problem. I think the uh pressures on the financial market, pressures on the real economy will slow this economy and that I think is a is a major concern uh and should be a major concern of both the administration, Congress and of course the Fed. Has the market understood that risk yet to financial stability? Is that priced in? I I keep hearing also from friends that risks are not properly priced in yet. What what is your opinion on that? >> Well, I think risks have not been properly priced. I beca I think they're becoming more so. If you look at the the pressure on the commercial banking, the largest commercial banking industry, you're seeing their their stock uh suffer uh if you will because of the uncertainties around uh all these events and and around the credit they have on their books. I mean, there's a whole array of conversations now about private credit in these banks. U banks have been lending to them. That's got people on edge uh in the market. So, I think I'm more concerned about economic and financial stability right now than I am inflation. uh although inflation will spike uh given the oil uh and that you know that combination uh I think they used to call stagflation is um more a possibility now than it was just a few weeks ago. >> Absolutely. Yeah. The the capital swword uh that Jerome Powell doesn't like to say out loud, but uh >> he he's been dancing around that word quite a few times in recent press conferences. Yes, he has. >> Um it has been interesting to observe and I'm really looking >> it's going to be harder for him to dance around it now because this is a perfect example uh of what happened in the 70s and I think um that was a period of stagflation and it was oil price shocks and a slowing economy. Uh and we have that combination at least in train now uh depending on how long this war goes. >> Well, exactly. So the question is what did the Fed do back in the 70s? Can we learn from what they did back then? Was it a mistake? Did they do the right thing? And uh what what should the Fed now do? >> Well, you know, the I think it'll be a tough decision. Um I think that if they obviously raise rates because they have inflation, that would be a mistake if it's oil caused. But also the problem is if they lower rates trying to offset the effects of the shock that will u that will put inflation more in train as well. So they're really in a difficult position and I think that'll be part of the discussion next week and that is do they hold steady and let this uh both the war the oil shock and the economy uh give them more signals going forward uh or do they try and anticipate that and I think their best course of action is to to wait carefully and let things work through a little bit. Now you can, you know, if things get worse, you can have interme uh inter period meetings uh among the FOMC. So it's not as if they make that decision, they can't change it. So they ought to they ought to try and watch and see. I think that would be the more prudent action on their part. Uh I would also point out that I think part of the reason they can be careful now is that when you look at where interest rates are 3 and a half% uh and inflation between 2 and a half and 3% real rates that's what really drives the economy in a sense are are closer to 1%. And that's that's not too far off the mark on equilibrium. think and many many think that uh the equilibrium rate is closer to say um more than 1%. So I think those are important things to keep in mind and I think there are things that the FOMC will have in mind as well. >> Absolutely. We just got some uh GDP data this morning as well or an update on the US GDP data and it's much weaker in Q4 than a lot of people have thought although we've been discussing this on our channel that the the real economy is much weaker than the numbers might suggest. Now we got a print of.7% in Q4 2025 revised down by 50% from 1.4% down to 7 which is a sharp drop from Q3 which was over 4% in Q3. Um how do you see the economy developing? Let's stay on the macro side for one second before we get more granular again. >> Well, the economy, you know, with the fourth quarter number was a disappointing number for everyone. I realize uh and I think uh there's a couple things you got to keep in mind. Starting at the first of the year, there were many tax um favorable uh actions take took effect in the first of the year. uh exemptions for tips, exemptions for overtime, um deductions on car purchases, uh some some a greater improvement in in the tax refunds uh given the the extension of some of the uh uh earlier tax benefits. So, those are those are stimulative effects that will take place in the first quarter. uh but I don't know that there will be enough depending on how uh the current economy uh uh is subject to oil price shocks to some concern about the condition of the banking industry and the private credit industry. uh all those uncertainties uh and then the uncertainty of the war. I think those are the negative factors that offset those beneficial tax uh actions that that are taking effect in the first quarter. So on balance I think it's it's more negative for the economy in the first quarter and beyond uh subject to uh changing circumstances internationally and no one I can't predict that no one can and I don't think the FOMC can and that's why I think being careful and holding carefully uh will uh uh be very important. Now, I do think that you'll see in the media and everywhere else that the prospects for a cut uh either sooner in 2026 or more cuts in 2026 will become a much more common topic. Uh as people anticipate a slowing economy, they would expect the Fed to ease and so would I. >> We're 99% for no cut right now. That's what Fed watch tells us or the CME Fedatch tool. Um, I think we I'm curious though, like I'm not I wouldn't rule anything out anymore for Wednesday personally, like given just the data we've been seeing and just what we're seeing of course in the Middle East and in general. So, I'm I'm not so sure why the market is so fixated on no cut right now. So, like I have my doubts. >> It's it's hard to know and that the the difficulty in any of that is the the uncertainty factor has just risen enormously. And when there's great uncertainty, people tend to pause and and and wait and hesitate. And that's true for the real economy. That's true for the financial economy. And we'll see how it affects the Fed because if that's the case and they see this slowing, they they may put they may find themselves saying, "Well, maybe we ought to cut." And that I think something they ought to be very careful about. >> It reminds me a bit of a deer in the headlights, of course, being caught between all that data and all of a sudden the lights are light the light is on them. How do you think like you're an insider of course at the Fed that's why I'm asking this but like how do you sort of avoid that and I'm not sure inertia is the right word but just like stoism just like when when you can't move like when you're stuck like I'm looking for that one specific word here mentally but when when you're stuck like how do you get out of that rut perhaps? >> Well I don't think that they're like deer in a headlight. I mean they they they can see what's coming uh and they can in fact uh you know is it is it is it real or is it not and they can make a judgment. Uh and so if if they think well wait a minute we're trading off here inflation, you know, we need to we need to wait. We need to let this fall through because if we move too soon, uh we're going to have a worse inflation environment. If and we know if we wait too long, we could have a um a a crisis on our hands. Uh so they're going to be they're aware of those choices. And that's why I emphasized to you earlier, they don't have to wait to the next meeting to take action. It's not like they can't move uh once they have more information and I think that may be how the conversation goes um at the at the meeting. >> No, no, fair fair enough. And I appreciate you clarifying that because uh the question is is it a train or is just a guy with a with a flashlight that's coming towards you? Right. So, >> right. Got to wait. Let's let's get a little bit of picture of what is coming at us. >> Exactly. Right. And and that's what we're trying to all of us are trying to figure out cuz we don't even know the length of what is happening in the Middle East. If it's done tomorrow, fantastic. But I think experts are predicting this might be drawn out. So which could be causing more chaos in the economy or global economy for that for that matter. >> That's a risk. That's a real risk. >> Absolutely. >> Um Thomas, you mentioned as well that the Treasury market is sort of the third mandate of the Fed. Uh we we talked about inflation already here, but third mandate is really the Treasury market. It has been interesting to to watch the 10-year yield uh move around. Uh it it rallied or the 10-year bond rallied and now it's being sold off again. Um sure. >> How do you put that into perspective for the Fed? Like how are they sort of following that because there's a there's a cap of course and they have stepped into the Treasury market on the short end recently as well. So how is the Fed dealing with the Treasury market right now Thomas? >> Well I think first of all they are beginning to focus on the short end because that's where they belong. they shouldn't be managing the yield curve. They know that and they would like I think they would like to get away from doing that. Um and that means the 10year and the longer side would the market would be more involved in determining that than the Fed. Now having said that the other issue that the Fed is confronting and that is that our national debt continues to rise at a clip of about two trillion a year. Um and you know that's pretty significant. And what that means is demand for reserves because someone's got to fund this debt is uh shifting. Uh and that puts upward pressure on interest rates. And I think that's why in part you see the the uh the Fed re-engaging in what you and I call quantitative easing as as of December. uh because they have to provide the reserves uh that facilitate the funding of that debt through the market uh by by allowing the market to have these reserves to buy to buy more government securities. So that's that's really a part that's entering this picture of uncertainty their need to help the government fund its debt or failing to do that interest rates will rise uh on their own. Uh and uh if you go back to December in the fall, the so-called u uh overnight funding rate um secured overnight funding rate was rising above the target Fed funds rate and the secured overnight funding rate is a less risky uh interest rate pricing on less risky asset that is secured uh securities and so um or secured borrowing. So what you had then was that was a sign that the market liquidity the availability of reserves to help fund this uh deficit was getting strained and the Fed stepped in to provide more liquidity into the market. So that's you know that process is also taking place right now. The debt has to be auctioned the Fed has to get it marketked. uh that puts upward pressure on interest rates and that's why you see the Fed uh putting $40 billion a month uh of purchasing of that government of government securities to free up some of the reserves for those purchases. So it gets very complicated. Now we have another factor uh influencing the Fed's policy choices. Uh just just to clarify also for myself, the the QE or nonQE QE that they've announced last year that is being executed right now, the 40 billion that you referenced, is that really just to buy on the short end or is that completely separate? Just just to clarify here. >> Well, I I don't know the answer to that, but I I think I think it's mostly on the short end. I've I've been I follow the the balance sheet. Now, one of their one of their other uh nuances of all this is that they're allowing the mortgage back securities, the that credit, which the housing market credit to run off. And then I I think part to to keep the 10-year from I guess becoming more volatile, they may be injecting uh funds in the 10 year to try and make sure that part of the yield curve doesn't become too uh too unstable. >> It brings me back to the the Fed put and uh is the market is the market expecting to be bailed out again in by the Fed for example as well. I think that's what the Fed put means here. um if QE is is maybe the first step in that direction. Um do you think the Fed will continue expanding its balance sheet and how will that show up and how will we notice that? >> Well um that is that is really a an important question. When the Fed announced its 40 billion it said it was temporary. I think they said you know through this tax season through the refunds. Uh but I I I remind people that the original QE was temporary. Uh so temporary by one's definition may be something different by another definition. I suspect given the pressure that the markets will face and that that will be there with this increased funding for the $2 trillion deficit that may grow with this war that the Fed will be under enormous pressure to help fund to re to keep the the the liquidity in the market uh in place. I think they'll be uh under pressure to to extend this this uh this $40 billion a month well into the rest of the year. That's that's a judgment on my part. Uh they could they could lower it sooner. That is reduce it from 40 to some much smaller number. I don't expect that to be honest with you right now. >> It's it's a good segue to discuss perhaps the new Fed chair that has been announced as well. He hasn't been confirmed yet, but because we need to talk about the Fed put always comes uh comes up in in conversation when the when we talk about maybe the S&P or the NASDAQ dropping massively and then the Fed could jump in and maybe ease monetary restrictions or just pump more money into the market quite literally to stabilize things. Kevin Walsh has been announced as a new Fed chair um by by President Trump. The question is why though? Um he's known as a hawk um or used to be known as a hawk. So, I'm curious, Thomas, um, any any insights on what he might have said during his job interview that he had convinced the president to announce him and why is he the right man for the job now? >> Well, I think u, first of all, I don't know. Let me let me clarify. Um, I'm like everyone else speculating, but I I I think part of what Kevin Walsh has said is that there ought to be a new Treasury Fed accord. And what that means is that the the Fed would be free to conduct monetary policy without the Treasury or the administration um getting in the way of that. But I think also what he's saying is uh what that did was it gave the market confidence that the Fed could do what is necessary uh to keep inflation under check. And when you give the market that kind of confidence, uh inflation expectations become more anchored. Uh there is less upward pressure on interest rates uh and you are able to then not have to raise interest rates or perhaps even lower interest rates. I would assume uh maybe incorrectly that that would be the the uh argument or the explanation that someone like Kevin Walsh would give. Now one of the difficulties about that is uh in the other instances in the past u even when there was a treasury court the actual deficit the increase in new debt every year was much smaller. Under current circumstances uh the the the debt is the deficit the new debt entering the economy each year is about 6% of our gross domestic product. In the 50s when the earlier accord was in place, it was closer to three or less percent of GDP. That's a lot less stress coming into the market to be funded. Uh and so that's going to be the challenge for whoever is the chairman and I suspect it will be uh Mr. Borch and uh that will be his challenge. How to convince the world that yes the Fed is going to make sure that inflation doesn't break out and therefore you can be confident of that. That is a very important part of his job going forward and that's going to be tough given the size of the new debt that has to be funded each quarter. >> Now it's political pressure is increasing of course on the Fed as well. President Trump just posted on on Truth Social again like we need to lower the interest rates tomorrow or actually immediately. I'm I'm paraphrasing. I don't know the exact quote of course. >> Um it's not getting easier for any Fed chair. Um or the Fed in general to to sort of navigate this market. Um how important is or what what's a bigger risk perhaps is the right question. Political pressure or fiscal dominance right now there Thomas? Well, they're they're two sides of the same coin. Um political pressure is going to be is enormous as you can see. Uh but so is fiscal dominance because um the the the debt has to be funded and um that means the the the that the foreign buyers and domestic buyers have to be willing to increase their holdings of of the national debt that insurance companies, pension funds, banks in the United States, foreign owners uh have to be willing to buy it. And is is the US debt uh something that more uh that people want to have more of? And that you don't know the answer to. But if they don't want to have more of it, that means pressure has to go on the Fed to pick up the excess supply of treasuries uh in the form of demand in the in uh to to increase reserves to allow that. And that's where they get involved in in basically monetizing more of the debt. And that that's the fiscal dominance side. Uh the the economy, the political pressure, lower rates so we keep things going, risking higher inflation versus we have a we have to fund this debt no matter what. If you let uh don't if you don't accommodate it, interest rates go up, so you have to accommodate it. That's the other side. The same pressure on the Fed from both sides. The Fed's job is to say, well, wait a minute, Congress, you've got to watch the deficit. uh the the economy itself uh has to get through this crisis period of war uh and the and the deficit. Uh we can't solve all those problems and they have to be able to explain themselves very carefully in saying that and in saying no to both fiscal dominance and to the shortrun needs of of any administ of any political uh side of the argument. Yeah, it's closely linked political pressure and the fiscal dominance side. I would I would agree because uh one helps the other because the the political side wants lower interest rate at least uh the the head of the you know the constituency or not constituency, the head of the White House like the president of course, right? We we know who that is. Um >> absolutely. Thomas, one last topic I want to touch on with you real quick is the private credit market. Um it it seems like there's a lot of pressure or and stress coming from that direction. uh loans that were in perfect standing in perfect health three months ago are now being written off as zeros. Uh we're just saw that we just saw headlines I think it was Black Rockck or um that that announced that as well. It was only a small $24 million loan um which was used in the Financial Times as an example, but it it highlights that healthy is not healthy anymore and uh the private credit market seems to be breaking. Um a what is your assessment of the private credit market and b of course what can the Fed do to help stabilize that private credit market perhaps? Well, first of all, the private credit market is designed to accept more risk, more risk than the banks are willing or able to accept. Uh so they're making loans to a higher risk category of borrowers. Uh and they are um they were able to do that in an environment of very low interest rates u more easily because their cost of funds were less. they could they the access to funding was uh easier and that all these funds started up and they began to make these loans. Well, then the economy uh as as the Fed did QE Q excuse me QT uh since 2022 until this past fall uh the the excess liquidity in the market was being slowly drawn out as the de as it was being shifted to funding the US debt. That meant availability of these funds were less. Interest rate pressures began to rise uh in 22 and then the excess liquidity began to run out. So these these private credit uh also had to find more loans to make of quality and they become more scarce because interest rates are higher. So now they're under pressure. Um these companies, these high risk companies, these leverage companies are now uh showing their their uh stains. Uh and the markets picked up on that. I mean these small failures as as as you know are an early indicator. Uh they may be the so-called canary in the mine coal mine. Uh and they have begun to show it and people are saying well wait a minute I want to get out first. It's a typical kind of bank uncertainty run because they're not their funds are not insured. Uh they're there and so that's going on right now. Uh and so I think it it is a bit of a run based on uncertainty. uh and I think that is the first step. The second step is the commercial banks, the largest banks have um been lending to these private credit companies so that they could become more levered and therefore increase their returns uh to their u to their limited partners, their so-called uh investors. And they've done that fairly extensively on the assumption that well, you know, they're in a sense diversifying because they don't, you know, they don't have all these loans. They all they have is this one loan and they can't all go broke. So now though that as the number of bad loans mount in these private credit, that puts more pressure on the banks and so you get the domino effect coming and that's why you see bank stock prices under pressure. That's the economy. uh the the what I call the inner uh inter relationships within the credit markets showing their effects. And so I think we have a a period ahead that will be a lot of stress on those credit private credit and uh stress on the banks who have loaned to those private credit and we'll they'll work their way through that hopefully uh without major crisis uh that would cause the Fed to have to step in. >> How could the Fed stabilize though? just by lowering interest rates to make money easier and cheaper to to access perhaps. Is that the only way? >> Well, there's a couple things. One is if people lose begin to lose confidence in the in that financial part of that is the banks lending to them, the Fed can provide money liquidity to those banks and that helps them fund and therefore stabilizes the market and the interbank market. But that's a temporary fix. What really has to happen is that the we have to settle through these private credit have to get through their their losses, stabilize uh probably at a smaller there'll be a smaller size but stabilize and that allows the banks to stabilize and the Fed can provide liquidity during that process but it cannot provide capital. And so that brings us to the other point. Are the institutions sufficiently capitalized to withstand the downward pressure? And that's interesting because the Fed and the other agencies have eased the capital rules recently uh at the very time that the capital is going to come under pressure. But I hope uh and I'm use the word hope because I don't know that there is sufficient capital to say, "Oh yeah, we can absorb that. We'll get through this." Uh yes, would take some hits to our bank stock, but the capital's there. uh and that means that's the ingredient to sustainability and confidence and I hope the banks are able to show the world uh and I hope these private credit are able to show the world that they are well capitalized and that's a question mark I can't answer >> no fantastic Thomas that that was wonderful I have one last question for you maybe just a bit of a summary question as well is there anything that the Fed could do uh or what could be the biggest policy mistake the Fed could do here in the next 6 to 12 months Well, the biggest mistake would be to panic and start massive QE. Uh that would ignite the inflation later on. And the other is to say, wait a minute, we can do nothing. Uh they need to be very I mean they they need to work with the controller and the FDI. They need to know the condition of their banks. They need to make sure they're in strong position because the banks are critical to stability and uh getting through this this uncertain difficult time. >> No, fantastic. Thomas, tremendously appreciate your time and insights. >> Um can't wait to do this again soon. We got to do this more often. Every nine months takes too long. There's so much going on. Um fantastic insights. Uh Thomas, is there a way to follow more of your work? And uh I know you're distinguished senior fellow over the Macato Center. Um, where where can we follow your work? >> Well, uh, we're on Substack on Finn Red Drag. It's called Finn Ray Rag on Substack. And I I put pieces out there occasionally uh recently on the on the issue of the debt deficit and the and the Fed's funding. I've done some other work on the capital and the uncertainties around the the deregulation environment. So, people can read that uh online on Substack on Finn Red for the Micada Center. >> Fantastic. Thank you so much, Thomas. It was a great pleasure catching up. I hope you're having a good Friday the 13th and uh we'll talk very soon. Thank you so much. >> I hope I make it through. All right. >> H you'll be fine. You'll be fine. Superstition, right? >> Awesome. Thomas, thank you so much. And everybody else, thank you so much for tuning in here to Sore financially. What a wonderful discussion about the inner workings of the Fed. What are they taking into consideration and what should they be doing right now? Well, one thing they shouldn't be doing right now is panic, as Thomas said, and I think that's something we can all agree on. We got to be careful that inflation genie needs to stay in its bottle for a little bit longer before things can happen because the oil price will add enough pressure anyway. So, thanks so much for tuning in. If you haven't done so, hit that like and subscribe button. It helps us out tremendously bringing phenomenal guests like Thomas Hernick here onto the program and we just appreciate it as well. Take care out there. Don't let the emotions run high. Don't let emotions guide your investments. Thank you so much. Take care.