Timing is Everything
“He danced on the knifes edge between awareness and sleep. When he dreamt like this, he was a king. The world was his to bend. His to burn.” – Maggie Stiefvater
I’m sure there are many days recently that Jay Powell, our current Federal Reserve chief, wishes he were on a deserted island with a cool drink in his hand. Unfortunately, he is in the unenviable position of trying to navigate our economy through the narrowest of gaps. On one side is the prospect of continued hyperinflation, and on the other, the potential to prick the mother of all bubbles.
Not that this is a scenario solely of his own creation. Since the beginning of the pandemic, our federal government, through its largess, has printed and pumped a previously unfathomable amount of money into our economy via direct payments to its businesses and citizens. Unfortunately, it appears that much of that money did not end up in the hands of those that truly needed it.
It did, however, manage to spark an inflationary cycle that certainly seems more than “transitory”. A New York Times piece in April of last year estimated that 15% of the $800 billion of PPP loans given out by the government were fraudulent. According to Yodlee, and based on the transactions of 2.5 million Americans, people earning between $35,000 and $75,000 annually increased stock trading by 90% more than the prior week after receiving their stimulus check. Americans earning $100,000 to $150,000 annually increased trading 82% and those earnings more than $150,000 traded about 50% more often. So much for helping out the “little guy”.
At the same time all this newly found money was being spent production collapsed. Small businesses were shuttered by the tens of thousands, taking significant amounts of goods and services out of the economy. Econ 101: A larger amount of money chasing a smaller amount of goods and services only pushes prices one way. Food, energy, commodities, real estate, stocks, non-fungible tokens (don’t get me started). It’s hard to find something that hasn’t seen a tremendous runup in price.
So far it has been the average wage earner (and those on fixed incomes) that has borne the brunt of this new inflationary cycle. According to the US Bureau of Labor Statistics wages were up 4.9% through October of last year. Unfortunately, prices were up during the same period by 6.2% as measured by the CPI (see my April 2021 Newsletter, “The Great Inflation” on what a flawed index this is, and how it underreports actual price increases).
So, what’s a poor Fed Chairman supposed to do with all this (besides wishing he had been in Janet Yellen’s seat a couple of years ago)?
One of the Fed’s primary tools for staving off inflation is higher interest rates. Low interest rates, however, have been the primary source of returns for the stock market (and all other assets for that matter) in the past decade. Besides directly setting interest rates, another increasingly utilized tool used by the Fed to influence rates has been “Quantitative Easing”. This is the expansion of its balance sheet through the purchase of US government bonds. The process begins with the US treasury printing dollars, and the Fed then using these dollars to buy the bonds. This action increases the price of the bonds and correspondingly decreases the effective interest rates on these bonds which in turn influences interest rates more globally. As the Feds balance sheet has increased, the stock market has moved in lock step. Of course, it also works in reverse (see below).
You may recall that Mr. Powell tried to raise rates in 2018. He had promised to raise rates by 2% over two years, but got only half way there by December. The stock market promptly lost nearly 20% of its value. Let that sink in. A 1% rise in interest rates caused the stock market to drop 20%. Jay quickly reversed course in January of 2019 indicating that interest “rates were a bit too high” (the exact opposite of his stance from a month earlier – funny what a market correction will do to one’s convictions).
The Fed has begun the process of reducing its balance sheet (red line above), which in the past has signaled a decline in the stock market. For now, it has not talked about raising rates directly, but continued price increases may force that issue.
So, it appears, Jay is in a bit of a conundrum: raise rates to stave off inflation, but potentially tank stocks, bonds, real estate, etc., or let the economy “run hot”. If prices continue to rise as they have, the pressure to “do something” will become intense.
That deserted island has got to be looking pretty good right now.