FWIW # 25 The Fed and Reality

FWIW # 25

FED Policy and Reality

This past week, Fed Chair Jay Powell announced a 50-basis point increase in the Fed funds’ rate with another 50-basis point increase coming next meeting. He then stated that the shrinking of the Fed balance sheet would be slower and less than the market expected. The market soared almost 1,000 Dow points before the close that day. The next day, the market declined 1,000 Dow points, followed by a decline on Friday and Monday. What’s going on is a legitimate question. While it’s not possible to know what the stock market collectively is thinking, it is reasonable to assume what the Fed is thinking. Challenges are brewing.

To fully understand, it’s necessary to start by reciting the two Congressional mandates the Fed has: (1) maintain a stable value to the currency and (2) work towards sustained full employment. Let’s take these mandates one at a time. First, the Fed is to maintain a stable currency or, said another way, keep inflation under wraps. In the last 20 years, economists have come to the conclusion that a 2% annual inflation constitutes a stable currency. How a currency can be called stable when it loses more than 20% of its value every decade can only be rationalized by economists with political leanings. What economists don’t want is deflation. Why? Because the economy will shrink as consumers, expecting prices to be lower tomorrow than today, slow their buying. Economists and politicians don’t like deflation because governments are essentially net debtors, depending upon tax dollars to allow them to exist and borrow against future tax revenues. If prices are going down across the board, government revenues will decline. They will borrow less and, therefore, provide fewer services. That’s a different discussion for a different time. Assuming a 2% inflation qualifies for a stable currency definition, the Fed has failed miserably. It’s important to remember one critical fact: INFLATION IS A MONETARY FAILURE. In this country, it is a failure of the Fed. It’s not a supply chain disruption; it’s not a natural experience coming out of a pandemic. Inflation is due to the Fed creating too much money for too long. Given the significant resumés of the Fed officials, there isn’t any rational case for the current inflation to be accidental. The fact that the current Fed chair has lunch once a week with the current Secretary of the Treasury, the case for deliberately knowing inflation was destroying the stable currency is even stronger. Despite their collective knowledge, for months, the Fed used the excuse that rising inflation was temporary, which was just their stalling strategy until inflation was deeply embedded. The Fed even continued expanding their balance sheet, pouring more money into the economy long after it was clear inflation was not temporary. Why? Why deliberately mislead the American public and set up the conditions for a ravaging inflation?

Understand that the Federal Government, as a net debtor of $30 trillion, is not unhappy about the current 8.5% inflation, other than the potential electoral consequences the party in power may face. Over $2.5 trillion of purchasing power value has been taken from the creditors holding that debt, as well as untold trillions of purchasing power from ordinary citizens, and the Fed is still deliberately adding to future inflation. Why? It all has to do with the fact the Fed is NOT independent from the political authorities in Washington.

The second mandate, full employment, is the focus of the Biden administration, Congress, and, frankly, the prior Trump administration. If the government truly wants full employment, they must flood the economy with money. Excess money, at regulatory-suppressed interest rates, will boost consumers spending, businesses hiring, and jobs being created. At least that’s what they say in the textbooks. The only problem is the textbooks don’t concretely define full employment, and politicians can’t see past next week, so they let their appointees at the Fed know to keep focused on unemployment.

Remember the weekly lunches of the Fed chair and the Secretary of the Treasury, who happens to be the Fed chair’s predecessor? While she was the Fed chair, she kept interest rates low and let it be known that her primary interest was full employment. We are in this high-inflation environment because of politics dominating the Fed. We will remain here for the same reason. Do not believe that the Fed nor the administration is worried about inflation. As stated, they are concerned about the November election; that’s why they pay lip service to fighting inflation and obscure the cause.

Once inflation, particularly inflation above 3%, is in an economy, the consumers and businesses begin to make economic decisions based upon the belief inflation will go higher. The cure for inflation is a recession. A recession (1) causes people to reduce or stop their demands for goods and services, (2) causes people who foolishly borrowed too much to get into financial trouble, and (3) stops prices from going up by reducing demand. A recession, however, does not cause deflation. The purchasing power that was taken from creditors, consumers, and businesses is permanent. Timing by the monetary and political authorities for taking the necessary steps to stop the inflationary spiral is critical. In the current situation, the Fed should have taken steps to lessen inflation last fall. They deliberately chose not to. Last January, they should have laid out and started the program for stabilizing the currency value. They did not. Finally, last month, the Fed couldn’t postpone any longer the acknowledgment that they needed to move to fight inflation. The markets took their apparent turn at face value, eagerly awaiting last week’s Fed meeting and actions. Markets were disappointed. The reality is the Fed has created a situation where inflation will continue at high levels (4% to 10% per annum) for an indeterminate period, eventually requiring actions that will cause an even more severe recession than was expected. The markets are looking past the continued easy money the Fed is still creating to the forceful actions necessary down the road to stop a more entrenched inflationary spiral.

The current selloff in stocks is to be expected since most of the last 18 months of speculative fervor was illogical. The dangers the stock market faces are two-fold. First, the recent speculative participants are likely to lose their capital and go away for another ten years. That means demand for stocks in general will subside. More importantly, a number of “Masters of the Universe” hedge funds have been decimated because they were all piled into the same growth stocks. If the market continues lower, these and other major speculators may cause a deleveraging downward spiral that accelerates, scaring small market participants into selling. Enhancing these swings in volatility on both up and down market days are the computer-driven speculators who trigger market volatility themselves.

Last week, the Fed abdicated their mandate for a stable currency. As far as stocks are concerned, selling now is a mistake, even though the probability of the stock market declining 35% more from here has risen to more than 60%, in my opinion. The longer the Fed suppresses interest rates and resists reducing their balance sheet, the higher that market decline probability percentage will go. It’s important to understand that in the intermediate to long term, well-run companies are the best inflation hedge there is. A market downdraft of 45% should be viewed greedily, particularly if the portfolio is constructed correctly and has liquidity to invest.

Interest rates, when and if the Fed allows the rates to be set by the markets, will move higher—much higher. How much, I have no idea. It does appear that the markets are about to take control of ten-year and longer rates, as the Fed stops QE2 actions suppressing them. As with everything in the markets, it is likely interest rates will overshoot the long-term inflation rate due to the inflammatory short-term inflation headlines. That will be a time to secure steady income by lending money again to borrowers (buying fixed income securities).

My major concern for the country is the way the current administration and Congress are gleefully trying to spit in Vladimir Putin’s eye. It is amateurish and stupid to taunt an evil person. It is hard to understand why experienced office holders and their appointees conduct themselves in this way. Do they truly believe Ukraine, even with NATO’s equipment, can defeat the Russian army? Do they truly believe Putin, if he were to face defeat, won’t strike back at NATO, including the United States, with all the power in his arsenal? The United States’ political and military leadership has failed to win every war they led us into since WWII. We have a cadre of political and military officials in Washington about to get this country in a cataclysmic situation because they don’t have the fortitude to stay out or commit to win. This leadership vacuum is evident in the monetary authorities as well. Perhaps the Fed knows more currency devaluation (inflation) will be necessary if the US gets more involved in Ukraine. The lack of leadership in both political parties and their appointees has the potential to wreck this economy.