The FOMC released its latest monetary policy statement.  As was widely expected, the Fed maintained its target for the federal funds rate between 5.25% and 5.50%.

Jerome Powell said that a rate cut in September is on the table if the inflation data continues to move towards the Fed’s 2% target.  It’s notable, but not surprising, that the Fed would even consider rate cuts until price inflation goes below 2%.

The American consumer has been hammered the last few years.  While the rate of price inflation has gone down, prices still continue to go higher on top of the major increases that have already happened.

I continue to believe that the Fed knows that there is a great risk of a major recession, market crash, and possible financial crisis.  Otherwise, why would they be talking about rate cuts while price inflation is still above their target?

The Balance Sheet

The Fed’s balance sheet continues to come down from its all-time high in 2022.  While the federal funds rate tends to get the most attention, the Fed’s balance sheet is perhaps just as important.

The Implementation Note from the latest policy statement shows that the Fed will continue to reduce its balance sheet.  It will continue to not roll over approximately $25 billion per month in Treasury securities and $35 billion per month in mortgage-backed securities.  This means that the Fed’s balance sheet should continue to go down somewhere near $60 billion per month, which isn’t an insignificant amount.

Sure, it isn’t a lot when compared to the massive money creation that happened in 2020 and 2021.  Still, it means that eventually something has to give.

When Ludwig von Mises wrote about the Austrian Business Cycle theory, he stated that even a reduction in the rate of inflation will eventually bring on the bust.  With the Fed actually reducing its balance sheet, this means we are not going to hyperinflation any time soon, and it means that there will be a bust of some sort.  This is what happens after a prior expansion of money and credit, and I think it’s safe to say that this expansion was too big to grow our way out of it.

In other words, if you have a small expansion of the money supply but growth and productivity far exceed that, then there probably won’t be any bust.  Perhaps prices won’t come down as much as they would have without the money expansion, but it seems to be painless enough.  That is not the case today because of how massive the money expansion was in such a short period of time.

Don’t Forget the Inverted Yield Curve

The yield curve is still inverted.  It was inverted for all of 2023, and it remains inverted today.  This means that longer-term yields are actually lower than short-term yields.  This has generally been a reliable indicator of a coming recession.

It is crazy that the yield curve has remained this inverted for this long.  If the severity and length of the inverted yield curve is any indication of the severity and length of the recession, then we should be in for a doozy.

Unbelievably, stocks soared before and after the Fed announcement.  It seems that almost everything is good news for the stock bulls these days.  Gold also soared, but that is a more recent thing, as gold has not had the huge run up that stocks have had since 2009.

It’s quite incredible that the Dow is nearing 41,000, while the Nasdaq is getting close to 18,000 again.  These gains for stocks are massive.  Just a return to the mean will mean a major crash in stocks.

If the Fed doesn’t step in quickly and aggressively when the fall starts to happen, I think we could easily see a 50% crash or more.  This might happen even if the Fed does step in quickly and aggressively.

Don’t Ignore the Bears

I sound like a broken record.  And I know the criticisms of people who sound bearish.  They say that the bears are eventually right but that you miss out on all of the gains in the meantime.

I can’t stress enough just how risky these financial markets are right now.  Americans are already hurting because of higher consumer prices and wages that won’t keep up.  But the people who own significant assets are a bit more optimistic because everything seems to be going higher with no end in sight.

What happens if stocks crash by 60%?  How optimistic do you think most of these people will be at that point?  The year 2008 wasn’t that long ago, but people have short memories.  How many hopes and dreams will be shattered when the much-hyped U.S. index fund takes a massive hit and doesn’t recover within months?

Again, I think the people at the Fed know the significant risks out there.  They are willing to accept a massive drop in stocks.  They are less willing to accept a financial crisis and bank failures.