Last week you saw the end of former Federal Reserve Chair Janet Yellen’s tenure leading the Fed. Chairman Jerome Powell is now shepherding the organization that holds the future of the U.S. economy in its hands. By raising and lowering interest rates they manipulate the economy from one market cycle into the next.
Since global economic growth has increased, all of the major central banks of the world (but Japan) have shifted away from the era of incredibly easy money over to financial tightening. The journey from huge quantitative easing and negative (or near negative) interest rates is fraught with risk though.
Already the Fed has increased its fed funds rate five separate times since it began back in December of 2015. They are hinting about three more rate raises in 2018.
New Federal Reserve Chair Powell has to be careful though. The Fed is constrained to tighten slowly for good reason. It was only in May of 2013 that the then-Chairman Ben Bernanke learned the meaning of “taper tantrum” every time he mentioned the goal of decreasing their Quantitative Easing asset purchases. Interest rates would dramatically rise and markets would drop at a dizzying pace.
The opposite concern for the Fed is not to tighten too slowly. They fear the over $2 trillion of excess reserves that they have provided the banks with in past rounds of quantitative easing. While the banks simply hold this money on balance sheet as an asset and as the Fed’s liability, there have not been any significant economic or financial repercussions.
Yet with economic growth increasing thanks to recently enacted tax cuts and probable major fiscal stimulus, this money will likely not sit idle anymore. Consumers will seek to borrow and banks will oblige them. The long-dormant excess reserves could quickly become real money circulating in the economy. This would then cause substantial inflation.
The Fed has already begun raising rates. If history is any judge, it will not end well. Their track record is to keep boosting the interest rates until it causes both a recession and a bearish stock market.
Since the end of the Second World War, 11 of the 12 times that the Fed has engaged in sustained interest rate increases have led to economic recessions. The only exception was a single so-called “soft landing” during the middle of the 1990’s. This chart shows their tightening cycles over the last several decades:
Is Your Retirement Portfolio Protected from a Fed Induced Recession?
Equities have yet another reason to fear the Fed. Recently rising bond yields only seem to have increased the Fed’s resolve to stop inflation from surfacing. Yet more expensive financing costs inevitably cause the economy to slow. This is because credit card interest rates rise, houses become more expensive to buy, and consumer confidence plunges. These combined effects generally lead to recession. The majority of analysts agree that such an event would spell the end of the current bull stock market. Fortunately you do not have to stay up late worrying about this potential alarming chain of events.
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