In the movie National Lampoon’s European Vacation Chevy Chase and his family get trapped in the inner lane of a roundabout all day; they can’t get out. And so it would appear to be the case with the Federal Reserve. Fed actions to control inflation can lead to stock and bond market crashes that will force it to backtrack its efforts, but backtracking will fuel inflation.
We’ve been here before when the Fed tapered its bond-buying program in 2018. In both cases, the stock market cratered forcing the Fed to end its tapering. How did that happen? Is the Fed caught in a trap and can’t get out? This time it’s different than before.
The trap
The following picture explains the trap. The Fed is caught in a roundabout that will require an aggressive and dangerous maneuver to exit.
In response to the financial crisis of 2008, the Fed adopted a zero interest rate policy (ZIRP) suppressing interest rates by paying a premium for Treasury bonds. ZIRP has in fact stimulated the economy as well as the stock and bond markets.
The Fed has printed about $5 trillion in quantitative easing (QE) to finance the manipulation and had planned to continue printing money, but then COVID happened. The government has printed at least $5 trillion in COVID relief so far, with more to come. Then it added another $3 trillion for infrastructure, and another $3 trillion is on the drawing board.
That $13 trillion in new money so far is more than our 10 most expensive wars combined. No surprise, inflation has reared its ugly head, helped in large part by supply shortages created by the pandemic. Supply shortages create Demand-Pull inflation. Money printing creates classic Cost-Push inflation where too much money is chasing too few goods.
Fighting inflation
The Fed has announced that it will taper ZIRP. This alone should allow interest rates to increase, but the Fed has announced that it will officially increase interest rates several times in 2022. When interest rates are not being manipulated, Treasury bonds have been priced historically to yield inflation plus 3%, so 10% in the current 7% inflationary environment.
But the Fed will try to keep the breaks on a return to normalcy because that would crash the stock market and raise interest service on the national debt well beyond affordability. The stock market is likely to react first because it is currently awfully expensive and dependent on low-interest rates.
Reversing course
When stock prices fall, the Fed will be pressured to reverse tapering to keep interest rates low, as it was in 2018. The problem this time though is that reverting back to ZIRP will require more money printing that will fuel inflation.
At the crossroads
The Fed will find itself tasked with a very tricky decision. It can manipulate interest rates, which will increase inflation because of money printing, or it can reduce spending on bond manipulation to control inflation, which will increase interest rates. Either interest rates will increase or inflation will increase.
Whatever the choice, something will break as the Fed escapes the roundabout trap.
Conclusion
It’s widely recognized that quantitative easing is a dangerous experiment of magnitude that has never been conducted before. And that was before COVID. The US and the world are in a very precarious situation, yet the stock market advances. Go figure.
Ron Surz is President of Target Date Solutions and CEO of GlidePath Wealth Management. He is also the author of Baby Boomer Investing in the Perilous Decade of the 2020s. He can be reached at Ron@TargetDateSolutions.com.