Conservative Investors Celebrate When the Fed Tightens

Stocks are all the rage today and investors who have shunned buying stocks until they are more fairly priced are struggling with the desire to dump their money into the stock market just in case this time things are different. Things are never different; they just take on a different form. Even though the Fed claims the business cycle is dead, the economic cycles are far from over. The Fed believes they can orchestrate a never-ending economic cycle, but they never do. Every time the Fed tries to rein in inflation, it leads to a  huge opportunity for those who have taken the more conservative path of investing.

When the Federal Reserve begins a monetary-tightening cycle by raising the Federal Funds rate or unwinding its balance sheet, the Fed begins the process that will lead to the next recession. For decades investors have ignored the Fed’s warning by buying technology stocks in the late 1990s or real estate in the early-to-mid 2000s just before the monetary lags of the Fed’s tightening cycle kicks in. Once the monetary lags kick in, the effects start a chain reaction of lower asset prices and debt defaults that become the epicenter of the next recession.

The Fed was designed to deal with currency-printing inflation, which was a problem for the early citizens of the United States. The architects of the Federal Reserve system gave the Fed a limited number of tools and a strict set of laws to follow that was specifically designed to eradicate currency-printing. Since currency-printing was a problem for the early colonists, the Fed was never given the tools or policies to print currency. The ability to conjure currency out of thin air was given to the banking system.

Only banks can create currency out of thin air as part of our fractional-reserve banking system, where one newly printed dollar has the potential to multiply itself numerous times before it is destroyed when the newly printed dollar becomes a principal payment on a loan. Today, a newly borrowed dollar can easily become more than one hundred dollars through its ability to multiply itself through our financial system.

Yet, investors believe the Fed has the tools to create currency-printing inflation even though they do not. The moment the Fed begins a tightening cycle, they kick off a cascading series of events that will lead to lower asset prices, lower interest rates, and lower economic growth. The pace and duration of the tightening cycle directly correlate with the length of the ensuing economic downturn or recession.

Easing monetary policy by lowering interest rates or engaging in Quantitative Easing gives the banking system more currency to multiply. When currency multiplies rapidly, it is the definition of inflation – when too much money is chasing too few goods. When the Fed eases it eventually expands the amount of currency in the system. The expansion of currency also leads to the expansion of debt and the expansion of the economy.

As the economy expands due to the Fed’s easing policies, asset prices rise, interest rates rise and consumer prices rise, which is similar to what happens when currency printing runs rampant. When asset and consumer prices rise due to easy monetary policies, it is not inflationary, as price inflation is simply a byproduct of more currency entering the broad economy.

Once the broad economy soaks up all the newly printed currency, asset, and consumer prices along with interest rates, fall. The solution to killing inflation is a matter of stopping the printing press or whatever mechanism is causing the currency to be created at a faster rate than necessary.

The notion that the Fed can create inflation by lowering interest rates to zero, or any other number, is completely preposterous. Every time the Fed eases monetary policy, the broad economy adjusts asset prices, interest rates, and consumer prices to absorb the newly printed currency. Once the economy has adapted to this new level of currency, the effects of inflation will disappear as the economy enters equilibrium with the level of currency.

The only way for the Fed to continuously stoke the flames of inflation is to maintain an easy monetary policy by perpetually lowering interest rates. There is only one problem with perpetually lowering interest rates, which is what happens after interest rates reach the zero bound. During the mortgage bubble, short-term interest rates were effectively negative due to the Fed’s Quantitative Easing. During the next recession, the Fed will have to use non-traditional means to lower interest rates. But to maintain the appearance that the Fed can create inflation, all the math, and economic textbooks will have to be rewritten as the world adapts to negative interest rates.

Conservative investors should celebrate when the Fed tightens, as those who are currently chasing stock prices higher will eventually find themselves selling their stocks into a Bear market. For those who were conservative but feel they missed out, recessions often create excellent buying opportunities for risk assets. The reason the economic cycle repeats itself is that the monetary system and the laws governing our monetary system have not changed.

Even though most financial professionals have not studied our monetary or financial system, they seem to believe the Fed can artificially and perpetually inflate asset prices. If the Fed were bestowed with such powers, there would be little doubt by now that the Fed, in conjunction with the Federal government, would continuously pump the monetary system to create everlasting prosperity.

The Fed fears currency-printing inflation, even though the Fed does not understand that each time they begin a monetary-tightening cycle that they are setting the stage for our next recession. It is not possible to deflate an asset bubble without creating a recession, despite the Fed’s best efforts. After nearly 100 years in existence, the Fed still has not gotten it right.

In the next recession, the Fed will likely restart Quantitative Easing, much to President Trump’s delight, who now is in favor of Quantitative Easing after being critical of it during President Obama’s tenure. While it appears that Quantitative Easing worked, it did not have the desired effects. Quantitative Easing did help reinflate the economy, but it did little more than creating asset inflation and a huge wealth gap. The primary purpose of Quantitative Easing was to offset the government deficits following the Great Financial Crisis.

The next time the Fed lower the Federal Funds rate and engages in Quantitative Easing, it will not have the desired effect. At first, it will appear to work, but as time passes, the economic benefits of easy monetary policy disappear. When those benefits vanish, the Fed will be faced with a nightmare scenario.

When the Fed lowered interest rates to zero during the last recession, they were setting the stage for interest rates to go negative during the next recession, even though negative interest rates are not easy to maintain. To hold short- and long-term interest rates near zero or negative, the Fed will have to engage in massive rounds of Quantitative Easing. When the Fed goes down the QE path again, they are going to find out like Japan has, that QE losses its effectiveness the more often it is done.

The reason the financial system will reach the brink of failure is due to the money multiplier, which is algebraically defined as the M2 money supply divided by the Monetary Base (MB). The money multiplier is currently at 4.4, meaning every new dollar entering the financial system will multiply itself 4.4 times before it is destroyed. When the Fed engages in QE it does not affect the M2 money supply, but QE can increase the Monetary Base.

When the Monetary Base rises faster than the M2 money supply, the money multiplier decreases. When the money multiplier decreases, the ability for new money to multiply falls, along with inflation. After all, inflation is a function of a rapidly expanding currency supply. When the money multiplier is low, currency cannot multiply and deflation becomes a persistent problem.

The M2 money supply is about $14.5 trillion and the Monetary Base is about $3.3 trillion. When the Fed pumps the monetary gas, they cannot force the money supply to grow. Should the Fed engage in another $4 trillion of QE like they did last time, and they will have to do much more than that, they will cause the money multiplier to fall below two.

When the money multiplier is below two, currency will barely change hands and inflation will be nearly dead. Inflation will not completely die until the money multiplier falls below one, and should that happen, the Federal government will have to change the laws to allow the Fed to print currency or find some other means to inject currency into the economy.

For conservative investors who avoid taking large losses during the next Bear market, they will have the opportunity to buy risk assets before the Fed realizes they have killed inflation completely. While risk assets do not perform well during hyperinflation, they do very well in the early years of any currency-printing scheme. For those who have taken the more conservative path, you need not worry, as your opportunity is coming to buy risk assets at the bottom of the next great Bull market.

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