Will the Fed Choose Financial Instability or Inflation?
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Over the past few weeks, Fed speakers were bemoaning inflation and voicing their wishes to squash it. They frequently mention how effective their monetary toolbox is in managing inflation.
There lies a massive contradiction between words and actions within these numerous speeches and media appearances. If the Fed is so intent on fighting inflation, why is it still stimulating the economy and markets with crisis levels of QE? Why is the Fed funds rate still pinned at zero percent?
With this ambiguity comes an abundance of risk for investors. If the Fed walks the walk and fights inflation vigorously, markets are ill-prepared for a sharp decline in liquidity and the resulting instability. Conversely, the Fed may be just talking the talk and hoping inflation starts abating. If so, it may not be as forceful as it appears.
The Fed is walking a tightrope between instability and inflation. Can it successfully tame inflation without causing severe market dislocations? The tightrope is thin, and the consequences of falling off to one side or the other are severe. Investors best think about the Fed’s perilous act it is getting ready to attempt.
The monetary toolbox
Since March 2020, the Fed has purchased nearly $5 trillion in government bonds, mortgage-backed securities, and corporate bonds. As the graph below shows, the annualized pace is greater than at the 2008-09 financial crisis peak.
In addition to QE and the abundant liquidity it fortifies financial markets with, it is also keeping the Fed funds rates at zero percent. The graph below shows that the real Fed funds rate level is obscenely negative.
The combination of massive liquidity and near-zero-percent borrowing rates have made speculative behavior commonplace among individual and institutional investors. The Fed removed $5 trillion of assets from the market resulting in more demand for all remaining assets. Further, it encouraged investors with near-zero interest rates to use leverage to buy more assets than they could otherwise afford. The result was the stunning rise in asset prices and speculative fervor.
Now, ask yourself what happens when the Fed removes liquidity and raises short-term borrowing rates.
Financial stability has become a critical element of the Fed’s vernacular since the financial crisis. While the Fed’s congressionally chartered mandate only mentions stable prices and maximum employment, Fed members consider financial stability a third objective.
For example, Cleveland Fed President Mester recently opined on reducing the Fed’s balance sheet.
I would like to reduce it – let me say this carefully, so that people don’t misunderstand – as fast as we can, conditional on not being disruptive to the functioning of financial markets.
Despite the Fed being woefully misaligned with its inflation goal, her comments clarified that financial market stability is of equal or even greater concern than high inflation.
Does the Fed’s “third mandate” make markets unstable?
In supplying generous levels of liquidity to markets and incentivizing leverage and speculative behaviors, it’s easy to make a strong case that asset valuations are well above where they might have been without the Fed’s aggressive actions.
There are those with a different opinion, so let’s focus on some facts:
- Using many different methods, equity valuations stand at or just shy of record levels seen in 1999. Almost all valuations have eclipsed those from 1929. Economic trends and forecasted growth rates are much lower than those periods.
- The 10-year U.S. Treasury note trades at 1.80% despite inflation running at 7%.
- BB-rated junk bonds trade at a record low 2.15% above Treasury yields despite more corporate debt than at any time in history.
Do the underlying economic fundamentals justify such extremes, or are they the result of massive liquidity and absurd amounts of speculation the Fed fosters?
Walking the tightrope
The Fed is making it clear it wants to reduce inflation. It is also telling us it will ensure financial stability. Sounds like a good plan, but walking the narrow tightrope successfully by achieving lower inflation without destabilizing markets is an incredibly tough task.
The odds of success are poor. As such, we must carefully consider which goal it will prioritize when instability arises.
Is the Fed willing to let some air out the financial markets to help get inflation moving toward its goal? Conversely, will a sharp drop in markets halt any Fed action toward reducing inflation?
These are the vast questions to which no one has the answers. That said, if the Fed falls off the tight rope, investors best start thinking about which option they will choose.
A key factor in answering the questions revolves around politics. The Democrats are at risk of losing the House and/or Senate. As November nears, it becomes increasingly likely the president will pressure the Fed to stem inflation. However, like the Fed, Biden may have to choose whether market instability or low inflation is a better outcome.
As you think about how Biden might ponder his choice, think about the following fact: 40% of the public has less than $1,000 of savings and rents. They do not have stocks to offset higher prices.
Can the Fed control inflation?
Another vexing problem facing the Fed is how much it can control inflation. The Fed can raise rates that will impede economic growth and dampen demand for products. However, it has zero control over supply-line problems and shortages. While some are alleviating, omicron resulted in a fresh round of new shortages and production problems. Our deep dependence on imports provides a reduced ability for the Fed to effect supply-side issues.
Wages are rising quickly, and the economy is at maximum employment. Companies aiming to preserve profit margins are being forced to raise prices with wages. A wage-price spiral is occurring already.
Lastly, let's consider the role of the Fed and its management over the money supply. In The Fed’s Inconvenient Truth, I wrote:
The amount of money greatly matters, but equally important is how it moves through the economy. The graph below compares the money supply chart above with the velocity of money and inflation.”
The circle above shows that during the high inflation of the 1970s, the money supply and velocity of money were rising. Today, we see a steep decline in velocity, offsetting a surge in the money supply. As such, most of today’s inflation is not the result of the Fed but the pandemic.
The Fed has a limited ability to affect inflation. It risks taking steps to halt inflation that does not meaningfully slow it but creates market instability.
I asked many questions in this article, but I do not have many answers. Given how high the stakes are, it is vital to consider the tradeoff between fighting inflation and risking market instability.
It is improbable the Fed can remove liquidity at the pace it is discussing without harming markets. The Fed can affect inflation but cannot truly manage it. It is possible inflation will diminish on its own over the coming months. However, it is likely to stay elevated throughout the year.
Understanding and preparing for the many possible paths is how to achieve success. I hope this article stimulates you to consider the diverse paths ahead and the choices facing the Fed.
Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.
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