The Federal Open Market Committee (FOMC) released its latest statement on monetary policy.  As expected, the federal funds target rate was raised to a range of 1.75% to 2%.  You can see the latest statement with the changes made as compared to the previous statement.

In order to control this overnight lending rate for banks, the Fed has been raising the rate it pays to banks on reserves, as stated in the FOMC’s Implementation Note.  Up until now, the Fed would raise the interest rate paid on bank reserves to the upper limit of its targeted federal funds rate.  For example, when the range was 1.5% to 1.75%, the Fed was paying 1.75% interest to banks.  However, in its latest statement, it raised the interest rate paid on required and excess reserves to 1.95% (instead of 2%).  This is more of a curiosity than anything, but perhaps the Fed didn’t raise its target rate quite as much as stated.  The range of the federal funds rate went up 0.25%, but the interest paid to banks went up 0.20%.

The Fed is also continuing on its path of monetary deflation, at least in terms of its balance sheet.  The Fed will continue to roll off a total of approximately $30 billion each month.  But according to its Implementation Note, this will increase to $40 billion in July.  This will be $24 billion in Treasury securities and $16 billion in mortgage-backed securities.

This is really the biggest story.  The Fed can impact the market interest rates to a certain degree, but the money supply is the bigger factor.  If this tightening leads to a recession at some point, then the target federal funds rate isn’t going to mean that much.  Market interest rates will go down most likely (especially long-term rates), regardless of what the Fed does, as investors seek safety in U.S. Treasuries.

The FOMC statement comes just a day after the latest consumer price inflation (CPI) numbers were released.  The year-over-year CPI for May 2018 stands at 2.8%.  The much more stable median CPI even went up to 2.7%.  This gives a green light to the Fed to continue its policy of tightening, but it may find itself in a bind if there is a conflict with rising prices and slowing economic growth.  I’m not ready to say that it is the 1970s all over again, but there was a slight step in that direction this week.

While I will continue to monitor the CPI numbers, I still think by far the most important thing to watch now is the yield curve.  I like to look at the 3-month versus the 10-year yield in particular.  If these yields start to get close, this will be a recession warning indicator.

I really believe that the yield curve will flatten, if not fully invert, before we will see a full-blown recession.  And it would not surprise me to see the short-term yields go higher in the coming weeks.  If the 10-year yield stays around the 3% mark while short-term rates creep higher, then things will really start to get interesting.

The Fed is indicating that it plans to raise its target rate two more times this year.  Of course, we know this can change quickly if economic conditions change.  The Fed is also planning to go full speed ahead with its balance sheet reduction.  This is eventually going to take its toll.

There is no reason to be in panic mode of any kind, but I don’t recommend being heavy in stocks anyway.  I recommend a permanent portfolio.

If the yield curve flattens or inverts, then I plan on doing a little speculating by shorting the stock market.