The FOMC met this week and released its latest statement on monetary policy on Wednesday, June 15, 2022. The Federal Reserve is hiking the federal funds target rate by 75 basis points, which is 0.75%. The Fed had not hiked this much since 1994.
The FOMC statement, much like Biden, tries to pass the blame. The statement reads, “The invasion of Ukraine by Russia is causing tremendous human and economic hardship.” Of course, the U.S. government doesn’t have to sanction Russia and refuse to buy its energy.
The FOMC statement also blames “supply and demand imbalances related to the pandemic.” Maybe I should be happy that it says “related” to the pandemic instead of “due” to the pandemic. But let’s be clear that it was governments everywhere and those who supported their actions that would be to blame here. It wasn’t a virus that caused supply and demand imbalances. It was the hysteria and the lockdowns and the ongoing rules and regulations that have caused imbalances.
Anyway, regardless of war in Ukraine or supply imbalances, the Federal Reserve is primarily responsible for the high price inflation and the situation we are in. This is what happens when the Fed more than doubles the balance sheet in less than 2 years time, while the government hands out massive stimulus checks to individuals and businesses through deficit spending.
Even though the Fed has typically used another measure, it was admitted that the recent CPI showing of 8.6% had a direct impact on the decision to raise the rate by 75 basis points. If the CPI numbers for May had come in below 8%, I don’t think we would have seen anything more than a 50 basis point hike.
Almost all of the focus is on rates. This is important, as it somewhat serves as a price for money. It is obvious that it will have a direct impact on mortgage rates. It has already had an impact, as most mortgage rates are now well above 5%. This will likely have a major impact on housing prices.
The higher yields might encourage people to save their money a little more, even though rates are still well below the rate of price inflation. Still, you might actually be able to buy a Treasury or bond that yields more than a tiny percentage.
The Money Supply
For some reason, the actual supply of money gets less attention. From the FOMC statement, here is the key sentence:
“In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in the Plans for Reducing the Size of the Federal Reserve’s Balance Sheet that were issued in May.”
The Fed has a plan to slowly reduce its ultra-bloated balance sheet. But it will be at the same pace as laid out in early May. So the Fed isn’t actually tightening any more than expected at this point.
Prior to 2008, the Fed’s target federal funds rate would go hand-in-hand with the base money supply. If the Fed wanted to raise the federal funds rate, it would typically sell off assets or not roll over maturing debt. In other words, it would shrink its balance sheet if they wanted to raise the overnight lending rate for banks, which is the federal funds rate.
Now, the Fed controls the federal funds rate by paying interest on bank reserves. You can see in the Implementation Note issued June 15, 2022 that it raised “the interest rate paid on reserve balances to 1.65 percent”.
The Fed could technically raise its target rate without decreasing the money supply now. In fact, after the first rate hike in March 2022, the Fed was still slightly adding to its balance sheet.
This means that the Fed could technically get away with monetary inflation while still acting like it is fighting inflation by raising rates.
The reason I bring this up is because it is not so obvious that this 75 basis point hike will do that much to combat consumer price inflation. Real rates are still deep into negative territory, and the balance sheet just recently peaked near $9 trillion.
The asset bubbles that have relied on this loose money are certainly seeing some of the air come out. But just because your stock portfolio is going down, it doesn’t mean the prices at the grocery store are going down.
Recession Looms
Meanwhile, there is news today warning that the second quarter GDP may be flat. The first quarter was already negative. So by the government’s own measure, we may be in a recession right now. Even if we aren’t in a technical recession, there is no question it is a period of slow growth to say the least.
This puts the Fed in quite a predicament. It is a predicament that it hasn’t really experienced since the late 1970s and early 1980s. We may be in a recession while price inflation is roaring.
With every recession of the last 20 or more years, the Fed has reacted with an aggressive monetary policy (i.e., digital money printing). What happens if we are officially in a recession while asset prices are plummeting? Will the Fed reverse course, or will it continue to “fight” inflation?
I don’t know the answer to this. They will be stuck. My hope is that they continue to tighten and allow a deep recession to happen. It is painful in the short run, but it tends to be better for the long run. It is called a correction for a reason. It serves to correct all of the misallocated resources.
My fear is that the Fed will try to appear to be fighting inflation by continuing to raise its target federal funds rate (or at least not lower it again), while at the same time allowing its balance sheet to expand. It may actually be able to get away with it for a while.
But it will only make things worse and partially delay the inevitable. All of the malinvestments are a result of the prior loose monetary policy from the Fed. We need a major correction to flush out the bad stuff.
If the Fed does get spooked by a recession and a major fall in asset prices, and the Fed officials decide to stop tightening, then I will have to reconsider some of my investments. The Fed has had a way in the 21st century of quickly reigniting asset bubbles.
For now, the Fed is in a more tight money mode. The yield curve is flattening. I see a recession ahead, if it isn’t already happening now. I think asset prices will continue to go down, but it obviously won’t be straight down.
If the Fed reverses course, then we can reconsider our options. For now, I don’t like the general stock market.