The Fed Strikes Again
This week I was planning on writing about how the Fed’s policies are going to prevent the economy from fulfilling President Trump’s campaign promise of generating 3-5% annualized GDP growth, but as of Tuesday, that topic isn’t what’s on my mind. For those of you who don’t know, I begin the weekly newsletter on the Sunday prior and I rarely deviate from the topic I choose for the week. Here we are on the eve of Janet Yellen’s last official meeting as the Chairman (of the Federal Reserve) and it is largely expected she will raise the Federal Funds rate. For reasons I can’t explain, the stock market seems to think this is a good idea because stock prices are up today.
I think what bothers me about all of this is how the Fed is deliberately sabotaging our economy and nobody really seems to care. People will care, but not until stock prices are falling or the unemployment rate starts rising. Unfortunately, people should care now because we are in the late stages of the largest debt expansion in the history of the world. Using history as a guide, the four depressions our world has experienced were all due to an unsustainably large run-up in debt. For some reason, central bankers seem to think that more debt can solve a debt problem. It never has, and it never will. As I just mentioned, major debt expansions are followed by severe contractions in the economy. This time will be no different.
Tuesday morning the Producer Price Index showed that producer (think manufacturer) prices are rising. Yet at the same time, consumer prices aren’t. The devil is in the details – producers are experiencing higher costs and are unable to pass those costs on to the consumers. These costs can’t be passed on because consumers are financially strapped, which should be evident that the growth rate in retail sales has fallen over the past three months while credit card usage has skyrocketed during the same time. Also, real hourly average earnings have contracted the past four months straight. What this tells me is that there is something structurally wrong with our economy and the Fed is about to trigger another recession or worse, depression.
Here we are on the eve of another Fed rate hike, which is completely justified by the increase in producer price index. The Fed is simultaneously reducing their $4.5 trillion balance sheet that’s made up of mortgage-backed bonds and U.S. Treasury bonds to combat inflation or the fear of future inflation.
The Federal Reserve oversees managing inflation and deflation – inflation takes the form of reducing the value of our money and deflation is the increase in the value of our money. The Fed wants to moderate inflation but wants to avoid deflation. Deflation increases the value of debt, which isn’t good when you have historic record levels of debt across governments, corporations, institutions, and consumers. What the Fed wants to do is gradually increase prices to cover up all the debt, so we can pay the old debt with future dollars – those future dollars being worth less than our dollars today.
Perhaps the reason I’m wound up on this topic today is that the Fed is going to eventually crash the economy, just like they always have. I wish I could say it’s because I haven’t finished my Christmas shopping or something like that, but it’s not. I’m just disappointed that the Fed and the other central bankers of the world have built the biggest bubble in history across numerous asset classes and the only two options are to keep inflating the bubble or let is burst, even though all bubbles eventually burst anyway. Believe me, you don’t want to see the latter happen, but the Fed is actively pursuing that path.
As I have likely mentioned in prior updates, the Fed doesn’t control how much money is printed. Following the Great Financial Crisis of 2008-09, the Fed printed over $4 trillion to reflate the money supply. So, the Fed expanded the money supply to counter the deflationary effects of falling wages and asset prices by creating more debt. What I find odd about their solution is that debt is inherently deflationary. The more debt someone has, the less money they have to spend in the real economy. That is unless wages rise faster than the debt payments, but they haven’t for the last two years.
I decided to try to figure out what the source of the producer price inflation and it turned out to be the Fed itself. Yes, the institution that is in charge of managing inflation and deflation is the source of the problem. That same institution is also getting nervous about inflation and is actively tightening the money supply, which has triggered every recession or depression since the advent of central banking. Let’s go through the cycle:
- The collapse in the Money Supply – This all starts with a recession or economic downturn where the Fed is forced to lower interest rates and buy bonds through Quantitative Easing programs to reflate the money supply.
- Bank Lending Expands – After being recapitalized by the Fed and aided by low interest-rates, banks eventually begin to lend.
- Economy Rebounds – In the years following the recession the money supply expands, and the economy slowly recovers.
- The Late Stages – About six-to-seven years into an expansion the Fed decides the economy doesn’t need supporting so they start preparing Wall Street for higher interest rates and the eventual unwinding of their balance sheet.
- 2-Year Treasury Yields Rise – For a period of time, the Fed will indicate they are going to raise rates and perhaps share the conditions that will cause them to raise rates. In the meantime, Wall Street slowly starts unloading their short-term Treasury debt because they don’t want to get stuck with it when the Fed hikes, which causes short-term yields to rise.
- The First Hike – As 2-year Treasury yields rise and nothing collapses, the Fed finally gets the courage to raise rates. Wall Street continues to sell off their 2-Year Treasuries which gives the Fed further confidence to hike.
- The Money Supply Starts to Fall – The purpose of raising interest rates is to curb bank lending, which in turn causes the money supply to fall. Unwinding the Fed’s $4.5 trillion balance sheet has the same effect. As the money supply falls, short-term yields rise.
- (Notice the feedback loop that starts somewhere around here. The Fed contracts the money supply which in turn causes short-term yields to rise. Rising short-term yields leads to inflation. The Fed continues to hike to control inflation, which causes the growth rate of the money supply to continue falling. Eventually, the money supply falls to a level that causes the system to break because there is too much debt in the economy and not enough money to service it!)
- Inflation – Consumer prices start to rise which makes the Fed happy because they are hoping wage growth follows. It starts to, but wage growth lags behind.
- Balance Sheet Unwind – As the minuscule rate hikes seem to have no effect, the Fed then moves to start selling off their bond portfolio, which began in October 2017 and is set to increase in January 2018.
- Inflation Heats Up – Prices start to rise which causes the Fed to get anxious. Little does the Fed realize that raising the Federal Funds rate keeps pushing 2-Year Treasury yields higher. Higher short-term yields will crimp earnings and profits when businesses realize they can’t pass those higher prices on to the consumer because, at this stage in the cycle, the consumer is nearly broke.
- Fed Keeps Hiking – The Fed wants inflation, but it doesn’t want too much. As producer prices rise and unemployment falls, the Fed thinks that inflation is going to spike, so they hike more.
- Recession/Depression – At some point, the Fed tightens the money supply enough through a combination of rate hikes and selling off their balance sheet that the economy seizes up and crashes.
Wednesday morning the Consumer Price Index (CPI) numbers were released that showed prices increased 2.2%, well below the Producer Price Index (PPI) that rose 3.1%, which validates my opinion that producers are having difficulty passing higher prices on to consumers. As further supporting evidence of my view, real average wages (wages less inflation), continue to fall and have contracted four months straight – something that hasn’t happened since 2009 when there was a growing concern of a double-dip recession.
And so the story ends with Janet Yellen hiking the Federal Funds rate one last time before her departure. The net effect of the rate hike will be to curb bank lending, which is about to contract on a year-over-year basis, which will be the first time bank lending has ever contracted outside a recession. The purpose of the rate hike isn’t just to slow the pace of bank lending, it’s a means to further reduce the money supply, which is already at a very low level of growth. If the rate of growth of the money supply continues to fall, it will likely cause our economy to seize up. To support record levels of debt, an economy either needs more money or it needs the existing money to circulate faster—neither of which are happening right now.
With the Fed tightening and the money supply falling, why is the stock market up and things like Bitcoin up? Because they are functioning like slot machines. Everyone knows that when the stock market gets to overly-elevated levels that it’s eventually going to rapidly fall – that’s not new. But when you’re in an economy where the central bank has run a series of programs that have benefited those at the upper echelons of our society, everyone else wants to benefit with them. Especially since the data shows that American’s have been financing their lifestyles on credit the past two years. Something like the stock market or a cryptocurrency gives investors the hope that they too can get rich. While I hope that works out for everyone playing chase, history suggests it won’t.
Unfortunately for all of us, there’s only been two ways out of a major money-printing, credit-expansion – a massive deflationary shock that either causes asset prices to plummet or hyperinflation. Neither are pretty, and both are something I’d rather pass on, but one is in our future. When the American consumer finally gives in and is unwilling to continue running up their credit cards, then our economy will finally break.
Video Topic of the Week – Auto Finance Companies
The big wave of lease returns is starting, and finance companies are losing money fast. Is this the end of cheap leases as we know it? Tune in this week to find out what’s going on with this sector.
Chart of the Week –
Lots of charts this week showing how the Fed creates too much inflation and then tries to combat it by creating more inflation, which eventually leads to a recession.
Portfolio Shield™ Update
No updates this week. Work progresses on the new strategy.
Weekly Broad Market / Economy Commentary
No additional comments this week.