Even with the Federal Reserve’s promise to continue its “extreme ease” policy for months to come, Wall Street has started to adjust for a more favorable environment: Normal (i.e., Fed-free) economic and financial growth from rising business activity, rising interest rates, rising inflation and rising stock prices.
Therefore, it is time to plan and act for the changes coming. In order to correctly focus on the future, we need to get a proper perspective about the Federal Reserve’s actions.
First: The Fed’s tactics are abnormal
Most views and commentaries retain post-Great Recession views despite the prolonged, pandemic-hyped actions being taken even as the economy recovers on its own and the financial system operates in top form.
The Federal Reserve’s extreme actions are keeping the Federal Funds interest rate at virtually 0% while purchasing at least $120 B of bonds every month. That means the Fed is committing to buy $1.44 T or more of bonds a year. Let’s not truncate that figure – the Federal Reserve Open Market Committee (FOMC), on its own volition, is monetizing bonds (i.e., creating money to pay for the bonds) in the amount of $1,440,000,000,000 or more per year.
Add in bank lending, the U.S. government deficits, plus the Covid-19 relief payments and the total money supply (M2) growth over the past year was $4 T – a whopping 25% increase. This graph shows the M2 rise along with the near-zero Federal Funds rate and the now-rising 10-year US Treasury note yield.
Even more extreme (and abnormal) is Jerome Powell’s promise to carry out its extreme actions for a “long time,” even as inflation rises above its 2% target “temporarily.”
Second: Some Fed actions are ineffective
The age-old reality is that the FOMC’s actions are only effective in two circumstances, at either end of the boom-bust cycle.
- First – obvious and welcome is when it acts as “lender of last resort” during times of financial system distress
- Second – controversial and unwelcome is when it acts as “party pooper,” tightening monetary conditions to cool down heady economic growth
Today is neither boom nor bust, the usual state of the economy. This period is when the Fed’s attempts to spur the economy are ineffective. The FOMC members’ flawed assumption is that low interest rates and increasing the money supply make conditions so desirable that they necessarily spur economic and employment growth.
From The Wall Street Journal article, “Fed Holds Steady on Interest Rates, Bond Purchases” (underlining is mine):
“Central bankers voted unanimously to maintain overnight interest rates near zero, where they have been set for the past year, and to continue purchasing at least $120 billion of Treasury bonds and mortgage-backed securities monthly. Mr. Powell said the measures ‘will ensure that monetary policy will continue to deliver powerful support to the economy until the recovery is complete.’”
The problem is easy money by itself does not produce a growth economy with rising employment, much less provide a “powerful support.” Like a horse led to water cannot be made to drink, organizations won’t borrow simply because the money is readily available. After all, it is debt that needs to be repaid, even if the interest rate is a bargain. Therefore, easy money or no, it’s improving business conditions that drive expansion.
That’s why the substantial monetary ease over the past twelve months has resulted primarily in the money just sloshing around in bank accounts and financial investments.
Therefore, it is time to prepare an investment strategy for the transformation ahead
Here are the issues coming that will produce major effects and transform views and outlooks:
First, rising inflation
This is the biggie. Its past tameness has the Fed now relaxing its role of inflation protection – at exactly the wrong time. The Fed’s explanation that good things will come from above 2% inflation repeats the misleading one-sided sales pitch they have used for all their radical actions. (Similar to the claim that low interest rates below the inflation rate hurt no one, despite the short-changing of the multi-trillions of assets held by savers and organizations that depend on interest income that, at a minimum, maintains purchasing power.) With a huge surplus of money and an optimistic outlook for growth, inflation will be a natural fallout.
Second, rising longer-term interest rates
Greatly misunderstood is this fact: The Federal Reserve cannot control longer-term interest rates. Those rates are under the control of Wall Street’s savvy bond investors. Therefore, as inflation expectations rise, longer-term bond yields will follow suit regardless of the FOMC’s Federal Funds rate (as they are beginning to do, shown on the earlier graph). Of course, when longer-term rates rise, bond prices must fall to adjust their market yields.
Third, rising stock market
Rising interest rates will not cause the stock market to decline. Instead, stocks will rise in line with the growth outlook, rising optimism and the growing need for inflation protection. Growth companies will naturally be desirable, but so, too, will be more stable companies that have “pricing power” (the magic phrase in inflationary times), whether it be for key resource ownership or for unique and desirable products/services. Add to these fundamental and analytical changes the flow out of bonds and other “safe” investments that are lagging or, worse, declining.
The bottom line: Prepare for the triple-rise by developing strategies for investing and personal finances
The underlying forces of the economy and financial system are sound, and the projections of growth look reasonable. Therefore, now is a time to plan for a return to “normal” – and that means a period in which the Federal Reserve fades into the background.
In such an environment, yields will provide real income, inflation will be rising to higher levels and the stock market will be cycling along, gaining sensible popularity.