The Federal Open Market Committee released its latest statement on monetary policy.  As was widely expected, the Federal Reserve is raising its target federal funds rate by a quarter percent.  The federal funds rate will now be in a range of 0.25% to 0.50%.

This drove up some yields.  The 2-year yield briefly hit 2%.  We will see in the coming days if this flattens the yield curve more, as shorter- term rates should rise a bit.  There is also the anticipation of several more rate hikes this year.

The Fed is in a bind.  We are getting hit with price inflation at about 8%, so the Fed has to start tightening or else risk losing control of the dollar.  At the same time, by tightening and increasing rates, an inverted yield curve becomes more likely, which is the warning sign of a recession.

It is also interesting that most everybody is focused on rates (meaning the federal funds rate, which is the rate the Fed can directly control).  Meanwhile, there is far less talk about the actual money supply.  While higher rates and a lower money supply tend to go hand-in-hand (or at least they did in the past), it is the money supply that ultimately dictates price inflation in the long run.

In the FOMC statement, it states, “In addition, the Committee expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting.”

Of course, “a coming meeting” could mean a year from now.

The odd thing is that the Fed is just now finishing up its taper.  In other words, up until now, the Fed was continuing to add assets to its balance sheet (i.e., create money out of thin air).

So now the Fed is talking about reducing its holdings at some meeting in the future?  Why didn’t it stop its money creation before now?  What is different now than a couple of months ago, other than the fact that price inflation is even higher?

In the Implementation Note with the statement, it says, “Roll over at auction all principal payments from the Federal Reserve’s holdings of Treasury securities and reinvest all principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities (MBS) in agency MBS.”

So the Fed will apparently stop creating new money for now, but will continue to roll over maturing debt.  It’s rather curious why the Fed would immediately start raising its target rate just as it finishes its massive balance sheet expansion.  One would think that the Fed would have stopped printing digital money long before.

The Fed’s balance sheet has gone from about $4.1 trillion to nearly $9 trillion over the last two years (March 2020 to March 2022).  Why didn’t the Fed stop adding to its balance sheet months ago?

They are trying to play a balancing game.  They can’t let price inflation get more out of control than it already is, but they also don’t want to risk imploding the economy and the Everything Bubble.

My prediction is that any significant increases in long-term yields will be short lived.  When recession fears increase, investors will still turn to Treasury securities for safety.  This goes along with the inverted yield curve where short-term rates go higher than long-term rates.

The only reason long-term yields would continue to rise is because there is a fear of even higher price inflation.  But if the Fed keeps raising its target rate and starts to consider a reduction in its balance sheet, this may be enough to prick the bubble.

At some point, something has to give.  The price inflation rate is unacceptably high at this point to most Americans.  I think the Fed is ok with it for a little while as long as it stays below 10%.  But let’s remember that price inflation just over 7% will result in prices doubling every 10 years.

We seem to be entering a period like the 1970s stagflation, but before Volcker became head of the Fed and forced interest rates well into double digits.  There are some key differences though.

We are starting from a point now where short-term rates are near zero.  If the Fed ever has to raise its target to rate into the double digits, we will be facing continued and steep increases.

The U.S. government is also in far greater debt now than in the 1970s.  Higher interest rates will mean higher servicing costs on the $30 trillion national debt.

We also have much bigger bubbles now than in the 1970s.  We may have bigger bubbles now than anything we’ve ever seen in this country.

At the same time, it is important to recognize that even during the 1970s stagflation, there were periods where stocks went on a bull run.  It may have been a tough time for Americans, but life still mostly went on.

The stakes may be higher now and the numbers a lot bigger, but we can hope that life will go on.  Times may be tough ahead, but we are not likely to turn into some third-world country, even if the U.S. dollar ceases to be the world’s reserve currency.

We don’t know if we will get higher price inflation or an economic downturn in the next year or two.  Maybe we’ll get both.  This is why I recommend a permanent portfolio, which helps you protect your wealth in any economic environment.

It is important to have a rainy day fund, even if it is sitting in the bank and losing 8% percent per year to inflation.  In a recession, cash is typically king.  In an inflationary recession, who knows?  But it is still good to have some liquidity for emergencies.

I will be following the yield curve with particular attention over the next few months.  If it inverts, you should prepare for a hard recession.