As widely expected, the Federal Reserve raised its target rate by 50 points today, its largest increase in 22 years.
Some market analysts were even predicting a 75-basis point hike. But today, Jay Powell reassured markets by claiming that he’s not considering such a move.
The stock market soared after Powell’s reassuring announcement. The Dow gained over 900 points today, with most of the gains coming after the Fed’s announcement. The S&P gained 124 points, while the Nasdaq gained 401.
Gold had a solid day, gaining over $13.
Importantly, the Fed also announced today that it’ll begin draining its balance sheet next month (in other words, begin quantitative tightening). The balance sheet is expected to decline $47.5 billion per month starting in June, increasing to a cut as much as $95 billion per month in three months.
Based on today’s market reaction, it seems that investors think the Fed will tighten policy enough to cool off inflation, but not enough to trigger a recession or a market crash.
I think they’re wrong. It’s wishful thinking. You only need to look at the recent past to understand why.
When the Fed tried to “normalize” monetary policy with rate hikes, tapering and quantitative tightening from 2013–2018, they failed miserably. The stock market crashed 20% from October through December 2018, even as the Fed kept raising rates as late as December.
The Fed soon began rate cuts and new rounds of QE. By April 2020, in the midst of a pandemic, the Fed was back where it started in May 2013 with zero interest rates and a bloated balance sheet (this time twice as large).
The Fed effectively proved that they could not normalize rates and the balance sheet without causing a market crash.
And now they’re at it again. The Fed started on a rate hike path in March with another hike today, and has made it clear they will raise rates aggressively through the remainder of this year (if not by 75 basis points at a time).
The Fed has also ended QE and will embark on an aggressive policy of QT beginning next month.
This time, the markets won’t wait five years to react. They’ve seen this movie before.
No Dry Powder This Time
Recession is not a wild card; it may already be happening. First quarter growth in the U.S. was negative 1.4%. A recession is technically defined as two quarters of negative GDP growth so we’re halfway there already and the Fed has only just begun.
Besides recession, a market crash worse than the Oct–Dec 2018 20% drawdown, and the March 2020 30% collapse should be expected.
This time the Fed is out of ammo to stop it. The Fed needs interest rates to be between 4% and 5% to fight recession. That’s how much “dry powder” the Fed needs going into a recession.
In September 2007, the fed funds rate was at 4.75%, toward the high end of the range. That gave the Fed plenty of room to cut, which it certainly did.
When the market crashed in 2018, the Fed wasn’t where it wanted to be, but still had room to cut rates by over 2%. When the market crashed in March 2020, the Fed still had room to cut rates and could greatly expand their balance sheet, which they did.
Now the signs of economic recession and market collapse are appearing at a time when rates are still below 1%, and the balance sheet is still bloated.
In other words, the Fed has no room to cut rates or print money to the extent that may be needed. The Fed’s toolkit is empty. Markets will now go their own way, which is down.
The Fed has two choices, both bad. They can continue to raise rates to squash inflation, which will worsen the recession and sink the stock market. Or they can throw in the towel, cut rates to zero, print money like mad, and do currency swaps with Europe and Japan.
That might prop up markets for a bit, but inflation will surge out of control. Inflation is just another kind of poison for stocks because it dilutes nominal values, hurts investment, and prompts a rush toward hard assets.
As I’ve argued many times before, the problem with any kind of market manipulation (what central bankers call “policy”) is that there’s no way to end it without unintended and usually negative consequences.
Once you start down the path of manipulation, it requires more and more manipulation to keep the game going.
Finally it no longer becomes possible to turn back without crashing the system. It’s like the famous song by the Eagles, Hotel California — you can check out any time you want, but you can never leave.
Of course, manipulation by government agencies and central banks always starts out with good intentions. They are trying to “save” the banks or “save” the market from extreme outcomes or crashes.
But this desire to save something ignores the fact that bank failures and market crashes are sometimes necessary and healthy to clear out prior excesses and dysfunctions. A crash can clean out the rot, put losses where they belong and allow the system to start over with a clean balance sheet and a strong lesson in prudence.
Instead, the central bankers ride to the rescue of corrupt or mismanaged banks. This saves the wrong people (incompetent and corrupt bank managers and investors) and hurts the everyday investor or worker who watches his portfolio implode while the incompetent bank managers get to keep their jobs and big bonuses.
Kicking the Can Down the Road
All that does is set the stage for a bigger crisis down the road. It just kicks the can, hoping that the latest intervention will be the last intervention. But it never is. It certainly hasn’t helped the economy.
In my 2014 book, The Death of Money, I wrote, “The United States is Japan on a larger scale.” That was eight years ago. Japan started its “lost decade” in the 1990s. Now their lost decade has dragged into over three lost decades.
The U.S. began its first lost decade in 2009 and is now in its second lost decade with no end in sight.
Investments in hard assets will preserve wealth (for those who can afford it), but they do not drive innovation and real growth. That will have to wait for another day.
In the short run, investing may be a case of every man or woman for himself. Nice job, Fed!
for The Daily Reckoning
Source: Daily Reckoning
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