Those few articles that say the Fed wants to cause a stock market selloff are nonsense. Behind the Fed’s anti-inflationary stance lies a larger goal: to restore the health of the US economy and financial system. “Health” means fully functional capitalism, which is organized primarily to ensure fairness. Doing so will bring back the growth stimulus that has been missing for more than a decade.
The way to health
For many years, the Federal Reserve usurped the key role of capitalism in the pricing of capital that results in a beneficial allocation of financial resources. The power of capitalism comes from ensuring that highly desirable activities and projects have the necessary financial resources – all at a price advantageous to the providers of capital: investors and savers.
Saying that interest rates close to 0% (which is highly abnormal by the standards of capitalism and history) were necessary to save the financial system in 2008 was understandable. However, extending that strategy into the next decade was not the case. The reasoning that “growth is OK, but not good enough” was an insufficient excuse to significantly bypass the primary role of capital markets. It also caused “hidden” pain to trillions of dollars in fair-income assets. Even worse, the Fed has caused important providers of capital to suffer an inflationary loss (purchasing power) every year.
So, why do you do that? To promote growth – right?
There is no evidence of good growth, let alone better growth. Indeed, Fed Chairman Ben Bernanke’s argument that growth wasn’t good enough was an admission that the Fed’s actions were ineffective. The conclusion that these measures should be extended and expanded is based on wishful thinking.
Moreover, there has been frustration with how the Fed’s generosity is being used. Without the pricing mechanism of capitalism (interest rates set by the market), there was no examination of borrowers’ monetary desires. Access to very cheap money allowed financing for poor or non-economic purposes. Examples include “dividend” payments, share repurchases, over-leveraged financial structures, and (worst of all) poor capital investments.
Over time and growth remained “too low,” Bernanke’s Federal Open Market Committee (12 economists) doubled down on the belief that they, alone, could improve the operations of capitalism by creating more money (called “quantitative easing”). However, this clever title means that the Fed has been espousing the mistaken and historically unproven belief that printing money can create real economic growth without spurring inflation.
As normal growth continued, the other shoe was down – the Fed pushed Congress to spend more (AKA, supporting “fiscal” growth). With interest rates remaining low and the Federal Reserve ready to buy bonds, the US government was free to borrow and spend at low cost. This long-disputed approach to using government spending deficits to produce growth without inflation was based on the theoretical work of the economist John Maynard Keyes. It was pushed through the 1960s and 1970s even as inflation continued to rise. However, the past decade has seen the government cut taxes and increase spending, driving deficits and debt into trillions of dollars with little regard for future fiscal consequences.
The Fed's first attempt to reset interest rates to the capital markets was a self-fulfilling failure
The rate hike from nearly 0% began hesitantly in 2016 under the presidency of Janet Yellen. It was then expanded more steadily under Fed Chairman Jerome Powell until 2018. At that point, the key 3-month US Treasury bond rate was 2.5% and the one-year inflation rate (CPI less than food and energy) was 2%, Finally generating a positive real return of 0.5%. This was a great achievement.
Unfortunately, that was not the case. Wall Street, whose interests represent 0% of the borrower, created a false fear. It was that the price of US 10-year Treasuries fell below the 1-year rate. Wall Street, yelling that it was an "inverted yield curve," claimed the cross was a sure harbinger of a recession. This claim was nonsense for four reasons.
- First, there were no excesses that required a slack correction
- Second, inversions can occur for other reasons without the following recession
- Third, the shifts caused by the Fed's rate hikes have produced an unusual period
- Fourth, the reversal came where demand lowered the 10-year bond yield, not because meager money drove the 1-year yield higher.
However, the Federal Reserve is the Federal Reserve, and economic theorists have succumbed to Wall Street practitioners. So, after the first "pause", Powell began to back off and give up what he had accomplished. (The 10-year and 1-year yield declines during the pause resulted in investors rushing to lock in returns before the expected Fed cuts occurred.)
What a shame, with investors and savers once again getting on the short end of the stick.
Then came the Covid-19 lockdown
The Covid-19 shutdown naturally caused the Federal Reserve and Congress to jump into action. As the actions of the past decade falter, the Fed's steps have been quick and easy: 0% interest rates and a massive increase in the money supply. On the financial side, Congress, facing an immediate problem (little time to discuss), has distributed the payments to everyone. After that, there were foundation subsidies and loan programs.
The procedures seemed to work as reopenings and rebounds started. While government payments are starting to fade, the Fed has maintained its shutdown stance - neither reflecting an interest rate cut nor rolling back the excess money created. As a result, as the economy begins to grow again, the way is cleared for overspending and its corollary, rising prices - inflation.
Finally, after saying first that the rate increases were "temporary," then "temporary," the Fed threw in the towel. Now, he has taken on the role of "anti-inflation".
Well, but look at the tactics: raise interest rates to a more natural level and reduce their bond holdings very slowly (thus reducing the excess money supply). In other words, without acknowledging their past misdeeds, the Fed is trying to be the white-hat protector of the health of the economic and financial system. Whatever...at least things are going in the right direction.
Wall Street failed to find its way again
A few weeks ago, the pressure on Wall Street was again on to use the roughly 10-year US Treasury yield for a one-year yield. Too tight money! recession! However, this time Powell resisted the outcry and continued, publicly saying that inflation had to be brought under control, even if it meant pain.
More importantly, the word "pain" has become a rallying cry for bears and the media. The mentality is now so negative that any news is delivered as another problem. (Good example - higher oil prices were the cause of the next recession. Now, lower oil prices).
Who wins and who loses?
think about this. Who is gored his bull this time, with rates soaring? The easy answer is all those who have committed to borrowing at low interest rates in the future. For example, highly leveraged companies or funds that will need to borrow in the future either to pay off current debt that will come due or to maintain growth with leverage.
Also hit were deficit spenders who needed financing - either through borrowing (including the US Treasury) or through the financing channel. The latter will be affected at higher rates as well.
Homebuyers were selected, but incorrectly. While higher mortgage interest rates are affecting affordability, the new 6% level is not a historic deal breaker. Rather, it is a reasonable level at which high-quality, well-financed financial institutions are ready to lend. The dynamics of the housing market are already adjusting favorably, with prices lower than their peaks, and buyers less willing to engage in a bidding war and inventory homes for sale for rebuilding. Apparently, those cash buyers who flocked to the market in the last quarter of 2021, looking for rental properties, also disappeared. In other words, normalcy is returning to the housing market, and this sets a better stage for future growth than the stress period we are now past.
On the positive side are savers and short-term investors. They are high. As well as non-speculative funds (eg, retirement, life insurance/annuities, nonprofits, state/local government, company reserves). And remember, increasing the income stream will improve financial health as well as allow for increased benefits and/or lower costs.
Bottom line: The benefits of the Fed's actions are already clear
Restoring the health and normalcy of the economy and the financial system will produce unexpected and highly desirable benefits. Currently, we are seeing a massive return to income for holders of the $22 trillion US money supply (as measured by M2). Using the current 3-month US Treasury yield of 3.2%, the potential annual interest income stream is about $700 billion, up from almost nothing. (By the way, to estimate the size of the money supply of $22 trillion - it is equivalent to annual GDP).
So... it's time to be optimistic.