Monetary Tightening

This month’s market update should be titled “How I Learned to Stop Worrying and Love Losing Money.” At least that’s what it feels like the Fed is telling us. The Federal Reserve has a pretty substantial credibility problem right now. A year ago this month the Fed was buying billions of dollars worth of mortgages (in the form of mortgage backed securities) amidst surging home prices causing home values to skyrocket. And doing this while stating that they did not see inflation on the horizon (spoiler alert, housing makes up about 1/3rd of CPI). A few months later in December, as they saw inflation ticking up, they stated the most they would have to raise rates this year to combat it would be 0.5%. Now, looking at the same data (home prices, jobs, energy) they are saying rates need to raise substantially, potentially to 4.5-5% for the Fed Funds rate, to quell the 9% inflation staring at them. The problem is the metrics used to measure inflation are backward looking. The Fed and investors understand this. Thus, policy actions taken by the Federal Reserve should follow accordingly and be pre-emptive rather than reactive. The Fed is mandated to facilitate price stability and maximum employment. On the employment side they are doing great (3.7% unemployment). On the price stability side, they are utterly failing. Not only is inflation soaring, but the value (market cap) of stocks and bonds in the US has declined by $57.8 trillion (based on Bloomberg data). At the very least they could express what they intend to look at going forward since they missed the mark so badly coming into this cycle.

Inflation was guaranteed to show up after the massive monetary expansion during the pandemic. The Fed increased the supply of dollars in the economy by roughly 41%, pushing up the prices on everything from stocks and homes to meat and fuel. Increasing the money in circulation is a healthy part of a functioning economy. A 5% increase in the supply of dollars correlates to roughly 2% inflation. If the Fed was not going to be comfortable with this current level of inflation we are seeing now, they probably should have made the treasury float their bonds on the open market to pay for the pandemic stimulus rather than buying them (printing money). This would have resulted in interest rates naturally going up as the supply of bonds in the market increased, potentially easing the transition to higher rates. Instead, what we got was very cheap and easy money and “dovish” speeches from the Fed through 2021, then an abrupt shift to monetary tightening pushing rates up faster than ever before. The dollar is at 20-year highs, commodity prices are declining, and the money supply is decreasing. The Fed is saying we need to remove money from the economy, and that we should all love this because it will drive down inflation. That’s all fine except for the fact that the economy is already shrinking, productivity is down, wages are barely inching higher, and trillions in valuation have been wiped out. Aggressively raising rates and removing cash will certainly tame inflation but it will do so at the expense of millions of jobs and people’s wages.

We don’t have a crystal ball, but here are some predictions of what is likely to happen. Inflation numbers will continue to look ugly in the Fed’s eyes as housing costs worm their way through the system. The Fed will want to continue rate hiking until it sees material deterioration in CPI, which could take over a year to manifest. During that time there will be an amplifying chorus from the business community and politicians to ease the pain as job losses mount and markets remain volatile. The Fed will eventually succumb, and their language will get more dovish with statements such as, “we are seeing a moderating of inflation” (even if they aren’t). At that time whether they cut rates, stop raising them, or do nothing the markets will rally. Inflation will then actually moderate as monetary tightening filters through the economy, market volatility will subside, and the Fed will get to decide if they want to start juicing growth by adding dollars back in – and the cycle will start over.

As an investor, the key is to remain diversified, disciplined, and patient. Every cycle rhymes but they are hardly the same script. How long a recession or bear market will last is anyone’s guess. But you don’t want to get left on the sideline (or worse, short) when the next bull market takes off. As has been stated here before and is still true today – stocks offer a better risk/reward than bonds and cash over time, even with increasing competition.