FOMC Monetary Policy – March 15, 2017

The FOMC released its latest statement on monetary policy.  As expected, it raised its target federal funds rate by one-quarter of a percentage point.  The target range is now 0.75% to 1%.  There was one dissenting member who wanted to maintain the existing rate.

This was not a surprise.  The market had already priced in this rate hike.  The Fed is now indicating that two more rate hikes are likely this year.  Stocks, bonds, and gold all soared.

The subject is now coming up about the Fed’s balance sheet of approximately $4.5 trillion.  Yellen is indicating that the federal funds rate is the main tool that is being used and considered at this moment.

The Fed has been rolling over maturing debt.  It has been its policy for a long time now.  The Fed could drain its balance sheet by letting debt mature and not replacing it.  But the Fed has little incentive to do such a thing, even though this has been talked about ever since the dramatic expansion began with QE1 in 2008/ 2009.

The Fed ended QE3 in October 2014.  It has been almost 2 and a half years, and miraculously there has been no recession yet.  The Fed’s easy money from the past has not haunted us directly yet.  The malinvestment in the oil market showed up, but not much else.  It has likely contributed to slow growth and a lack of savings and capital investment.  It has prevented a strong base for actual prosperity.  But we have not seen the major malinvestment exposed yet.

As long as the excess reserves do not pour out of the commercial banks, then I don’t expect price inflation to go considerably higher.  If price inflation does not go considerably higher, then I don’t expect the Fed to drain its balance sheet.  What would be its incentive?

The CPI numbers just came in for February.  The CPI for February showed an increase 0.1% from the previous month.  But the year-over-year is now 2.7%.  The more stable median CPI continues to show a 2.5% increase from 12 months ago.  According to the FOMC and Yellen, inflation expectations are still below their 2% target.

As I have stressed many times in the past, the Fed is not hiking its target rate by selling off assets, as it would have done in prior times.  Instead, it is raising its target rate by paying a higher interest rate to banks for their reserves.  This is free money for the banks.  It is also less money that the Fed will remit back to the Treasury at the end of each year.  If anything, this will just increase the deficit.

Right now, it is a wait-and-see game.  It is a wait-and-see game for the Fed, and it is really a wait-and-see game for us as investors and just as participants in the economy.  We’ll see if these rate hikes contribute at all to a shrinking money supply.  The only way this is possible is if it is enough to encourage banks to lend even less than they already were.

While the Fed’s target rate (overnight borrowing rate for banks) is not completely meaningless, we have to keep our eyes on the big picture.  This includes the Fed’s balance sheet, the excess reserves held by banks, and the price inflation rate.  The demand for money is also important, but that is virtually impossible to measure until after the fact.

We may be in something of a mini-boom right now, at least with some assets.  But middle class America is struggling.  And at this point, I still believe there is more downside for stocks than upside.  Is it worth getting another 10% out of stocks with the risk of them falling 30% or more?  Diversification is important now, and having a decent cash position is a good idea.  If we hit a recession, you can use the cash to purchase assets that have fallen in price.

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