The Federal Reserve released the minutes from the December FOMC meeting on Thursday (Jan. 5) and the markets freaked once again at the prospect of monetary tightening. The minutes seem to indicate an even more abrupt shift to tighter monetary policy to fight inflation. But I have questions.
First, a quick overview of the minutes. You can read them for yourself HERE.
The minutes give the impression that the Fed is really getting serious about inflation this time. Remember back when inflation was “transitory” and nothing to worry about? Those were good times.
Now it appears the Fed is worried. The minutes used the terms “elevated levels of inflation,” “elevated inflation” and “elevated inflation pressures” five times. By the way, there was no mention of the word transitory.
In a nutshell, the minutes indicated the Fed plans to tighten faster and more aggressively than expected to deal with this inflation problem.
The big news that took everybody by surprise was that the FOMC has started discussing balance sheet reduction. “Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate,” the meeting summary stated.
“Runoff,” aka quantitative tightening, was mentioned 10 times in the minutes.
According to the minutes, the federal funds rate could come “relatively soon.” Speculation is we could now see the first interest rate hike at the March meeting. But the minutes seem to hint that the Fed may rely more on balance sheet reduction and less on rate hikes. Quantitative tightening would bring up long-term interest rates, thereby ensuring a steeper yield curve.
The markets weren’t thrilled after the minutes came out. The S&P 500 plunged 1.9%. The Nasdaq plummetted 3.3%. The Dow Jones was down just over 1%, Meanwhile, the 10-year yield rose to 1.71% on Thursday. The 10-year was up 19 basis points over the three trading days of the year.
And as has been the case all year, gold reacted to the prospect of Fed tightening by giving up all of its gains from earlier in the day. But Thursday morning, the yellow metal was back below $1,800.
As you digest this latest Fed news, I have a number of questions you should consider.
- If there is suddenly such a sense of urgency to fight “elevated inflation pressure” why did the Fed add another $76 billion to its balance sheet in December? If the central bankers know that loose monetary policy is feeding the inflationary fire, and they really think the fire is out of control, shouldn’t they stop feeding the fire immediately? It’s hard to take their sudden urgency seriously when they are still pouring gasoline on the fire – even if it’s a little less gas than last month. As Peter Schiff has said repeatedly, a little looser monetary policy isn’t tight.
- If the Fed stops buying bonds and starts selling US Treasuries into the market to shrink its balance sheet, who is going to monetize the massive federal government deficits? Nothing the Fed does will stop the federal spending pandemic. The Fed has absorbed a large percentage of the federal debt issued since Jan 2020. In 2020, the Fed monetized more than 100% of notes and 90% of bonds. In 2021 those numbers fell to 31% and 46.5% respectively, but the Treasury issued more debt in notes and bonds in 2021 than it did in 2020. Who can absorb almost half of the long-term debt the Treasury will be issuing for the foreseeable future if the Fed bows out and then starts selling into the market?
- Why isn’t anybody talking about real interest rates? The yield on the 10-year is around 1.7%. The CPI gain for 2021 is already over 7% with the December data still out. And that’s using the government’s cooked CPI formula that understates inflation. That means the real yield on the 10-year is well over -5%. And with the actual inflation rate being around 15%, the real yield is well over 13%. This isn’t a negative for gold.
- Do you remember the last stab the Fed took at balance sheet reduction? After the ’08 financial crisis, the Fed balance grew from $898.6 billion in August 2008 to a peak of just over $4.5 trillion in Jan. 2015. The Fed didn’t get around to significantly shrinking the balance sheet until 2018. The central bankers claimed balance sheet reduction was on autopilot, but that didn’t last long. The stock market threw a tantrum in the fall of 2018 and the Fed swiftly reversed course with the last rate hike coming in December of that year. The balance sheet dipped to $3.76 trillion in late August of 2019. From there it took an upward trajectory. The Fed was already back to quantitative easing before the pandemic. That leads to the next question.
- If the Fed couldn’t successfully shrink its balance sheet after 2008, what makes anybody think it can do it now? The balance sheet now stands at over at just under $8.8 trillion. There is even more debt in the economy today than there was then. The economy is more addicted to low interest rates and stimulus than it was then.
- Do you remember Paul Volker? Volker orchestrated the monetary tightening that finally tamed the inflation of the 1970s. To do so, he took rates to 20%. If we measured CPI today using the 1970s formula, we would likely be seeing readings in the 15% range. That’s worse than the 1970s. In order to fight inflation, the Fed needs interest rates to rise above the rate of inflation. This leads to yet another question.
- Do you really think the Fed can push rates to 15 or 20%?
As you consider the ramification of these Fed minutes, make sure you take some time to consider these seven questions. They just might help you clarify your thinking.
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