In a fresh warning, the Federal Reserve has expressed deep concerns about the state of the US economy. According to a research note by two Federal Reserve economists, the number of non-financial firms facing financial distress has reached unprecedented levels, painting a bleak picture.

Since March 2022, US monetary policy has significantly tightened, and the share of non-financial firms experiencing financial distress has surpassed levels seen in previous tightening cycles since the 1970s. Currently, 37% of firms are distressed, a troubling figure that demands attention.

The economists argue that the true impact of the Federal Reserve’s sharp interest rate hikes may be on the horizon and substantial. They speculate whether the high number of distressed firms could significantly affect investment and employment, surpassing those of previous tightening episodes.

To put things into perspective, the total investment in publicly-listed firms, accounting for around 60% of aggregate US investment, is highly responsive to monetary shocks and is a vital component of GDP. Furthermore, employment within Compustat firms contributes to roughly one-third of US non-government employment.

Considering the current distress levels at 37%, preliminary estimations suggest that the recent policy tightening may exert stronger effects on investment, employment, and overall economic activity than past tightening cycles. The economists project that the peak impact of these effects will likely be felt in 2023 and 2024, signalling potential challenges ahead.

Worryingly, the Federal Reserve warns that its own policies may inadvertently push distressed companies closer to default, setting off a domino effect of unforeseen layoffs. The analysis may even underestimate the true magnitude of the employment effects, as policy tightenings could exacerbate the risk of firm bankruptcies, resulting in additional job losses not captured by the data.

As the Federal Reserve raises the alarm, it becomes evident that swift action is needed to mitigate the potential fallout from the distressed firms and the subsequent wave of layoffs they may trigger. Safeguarding the stability of these companies is crucial to prevent further economic turbulence and ensure a more secure future for the US economy.

It remains to be seen how policymakers and market participants will navigate this precarious situation. The fate of these distressed firms and the potential ramifications for investment, employment, and overall economic activity underscores the need for careful monitoring and proactive measures to support and stabilize the US economy in the coming years.