‘Reloading the Gun’ – The Federal Reserve

I was chatting with an investment banker recently about the Fed’s economic expansion policies (massive printing of capital in ‘20/’21) and its need to now slow down the economy (reduce inflation) by raising rates exponentially (Federal Funds Rate, rate hikes). Of which, the rate hikes he referred to as “reloading the gun”.

I found the expression comical. But also, rather frustrating.

The Federal Reserve Open Market Committee (FOMC) raised rates last week by 75 basis points (.75%). Tying a previous record for a single-meeting rate hike.

As I’ve said many times in the past. The Federal Reserve’s purpose is to give gentle nudges to the economy. With its main focus being twofold; price stability (inflation) and job creation (full employment). Inflation is at 40-year highs, due to pandemic-induced global supply chain constraints, Ukraine-Russian War (causing oil and food prices to increase), the immense amount of stimulus issued in 2020 and 2021 by the US Government to combat the pandemic and a shortage in the labor market and housing. All of which, hitting at the exact same moment in time.

With the US being at nearly full employment, there is essentially nothing on the other side of the scale preventing the Fed from aggressive interest rate hikes as its main tool to combat inflation. Raising interest rates gradually to slow the economy and reduce inflation will most likely trigger a modest recession and result in an economic slowdown. Key word: gradually. Recessions are never desirable, but with inflation running rampant, a modest recession is likely needed to bring the economy back to a healthy balance for longer-term stable growth. What we should be most worried about currently is that the Federal Reserve blows it – raising rates too far, too fast, and puts the US and global economy into a deep recession. If you’ve listened to the Federal Reserve commentary you’ll frequently hear the term “data dependent”. And in my humble opinion, that data is saying that peak inflation is upon us now.

The Fed’s preferred inflation metric, the Core Personal Consumptions and Expenditures (PCE) Index, has declined for two consecutive months after peaking in February. Given that core PCE and other economic data, the projected rate hikes to reach the Fed Funds target of roughly 3.5% – nearly double the current rate – now seems to be too aggressive and an act of fear, rather than data driven policy.

As a reminder, the Federal Reserve’s current policy is to take liquidity out of the economy by shrinking the Fed’s balance sheet, reversing quantitative easing, and reducing the money supply. They did the same in 2018, which resulted in a relatively painful period in late 2018 – hopefully the Fed has learned from the past and will implement a moderate pace for money supply reduction.  If the Federal Reserve is overly aggressive on rates hikes, or the money supply reduction, an economic recession and market contraction will be more severe and certainly more prolonged. Bumping rates slowly, following data, and keeping an ample supply of capital in the market should be the goal for a healthy economy.  One could only hope this is the direction FOMC takes.

We are in the middle of this temporary pain. How temporary is anyone’s guess, but typically it’s a 12 to 18-month cycle before the stock and bond markets work through the volatility – which we’re nearly 6-months into thus far.

The outliers here – which the Fed has no authority over – are Covid restrictions, as well as, the Ukraine-Russia conflict which has evolved to somewhat of a stalemate – putting tremendous pressure on oil and food supplies. The Fed can reduce demand for oil, but the energy inflation we are currently experiencing stems also from the supply side, which the Fed has minimal influence over. As for food costs, as the third-largest global exporter of grain, Ukraine produces a surprisingly high percentage of global crops for its relatively tiny size, and much of that output will take years to be replaced.

The risks on the table are clearly elevated and justify caution in the near term. Longer-term, we should be mindful that there has never been a moment in US stock market history when stocks did not go on to reach higher highs after a recession – sometimes in the shorter-term and sometimes in the longer-term. Bonds too should find a level at which they too begin to stabilize in value, and even appreciate as interest rates begin to fall.

All of this to say, I do not believe the Fed is simply “reloading the gun”. Its policy actions being based on “data dependency” should engendered few to no further interest rate hikes throughout the rest of the year while also slowing its reduction of the money supply. Allowing the scales, from where we stand now, to further balance themselves – in keeping with the ‘gentle nudges’ as the Fed was intended for.

Interested in learning more? Schedule a call with me HERE.

Warmly,

Mark Sauer
info@AllOneWealth.com
+1(310)355-8286