The Federal Reserve held a secret meeting on February 14, 2022.  We can guess that it wasn’t a happy Valentine’s Day for Jerome Powell and company.

The Fed is stuck between a rock and a hard place.  This is after getting away with massive monetary inflation and ultra low interest rates since the fall of 2008.

There have been major consequences from the Fed’s loose monetary policy, as it misallocated resources and allowed the government to continue to run up its debts at a significant pace.  But there never seemed to be an increase in consumer price inflation, at least by how the government measures it.

Now the CPI is coming in at an annual rate of 7.5%.  So it is widely expected that the Fed will start to tighten quickly. First, it actually has to stop its expansion of the balance sheet.  Most financial commentators tend to focus on interest rates instead of the money supply.

The Fed controls the federal funds rate, which is the overnight borrowing rate for banks.  They used to control this rate by increasing or decreasing the money supply, but now it is done more through other measures, including changing the rate paid on excess reserves.

Still, there is a correlation between the low interest rates and the easy money.  They go hand in hand.  As the Fed slows down or stops its balance sheet expansion, it will raise its target federal funds rate.

This will drive up short-term interest rates, which has already begun.  While there has been a lot of focus on the 10-year yield rising to 2%, the shorter-term rates have been more dramatic.  The 2-year yield has gone up to around 1.6%.

The 3-month yield has risen in less than two weeks from 0.19% to 0.43%.

The 1-month yield is still near zero.

When the 2-year yield goes above the 10-year yield, this will be significant.  It will be more significant when the 3-month yield goes above the 10-year yield, which could still take a while.

There is a lot of uncertainty in the financial markets, but an inverted yield curve is one thing that has been a near certainty through modern history.  When short-term rates exceed long-term rates, a recession is on the horizon.

I have somewhat discussed recession and a stock market crash in tandem, as if they will happen around the same time.  Perhaps this is a mistake.  It is quite possible that a crash in stocks could happen before a recession is evident.  Or we might see a decline in stocks for several months that isn’t too sharp, and then see a major crash when the whole economy goes down.

We may also see parts of the Everything Bubble go first before stocks.  It would not surprise me if cryptos, NFTs, and other major speculations fall hard before we see stocks fall hard.

Keep an eye on the yield curve.  If it inverts, you should prepare for a recession and a major downturn in stocks.  You should probably prepare for a major downturn in stocks no matter what.

The Fed is stuck.  If they keep the easy money flowing with low interest rates, then price inflation will just get worse.  If they slam on the monetary brakes too hard, it will lead to a quick and nasty recession.  Of course, the next recession will be nasty no matter what, but it is just a question of when.

The good thing about the Fed raising rates is that it will help expose the malinvestment, and it will hopefully force the federal government to restrain its spending at least a little bit.

I am happy I refinanced my mortgage last year.  I don’t know if we’ll ever see mortgage rates that low again.

Still, if the Fed can get the inflation under control and we see a major recession, long-term rates could fall again.  Bonds are the one piece of the Everything Bubble that may hold up longer than the rest, but that isn’t clear at this point.

Even though price inflation is roaring, it is still important to hold some cash/ cash equivalents, as things can change very quickly.  You won’t go wrong having some liquidity, even if it is currently depreciating at 7.5% annually.