We just had a 3/4% rate hike, the biggest hike in 28 years. Will taming inflation ensure a recession?
Right now there’s a multi-front war going on against inflation. Finally, after a lot of planning and discussion and debate, the troops have finally been engaged in battle.
First and foremost, of course we know about the 75 basis point hike. The Fed funds rate is 1.5%. That’s just a fancy name for the short-term safe money interest rate and it is the basis on which all other interest rates are built upon. We’re however only halfway to the goal of 3% and we were as low as zero after the pandemic. In fact, by 2023, it’s going to go up to 3.75%. So, this party’s not over yet.
This is affecting interest rates all along the yield curve, which is the fancy way of saying mortgage rates are going up. Intermediate term loans are going up. Car loans will go up. Interest rates are going up. In fact, the 30-year mortgage is approaching 6% as we speak and likely if these final numbers are reached there’s potential for these mortgages to hit 8%. That’s going to have a crushing impact on both home buying and construction. It’s going to price many people out of a lot of these markets and construction and all the industries that go with it. Furniture, maintenance support for houses all of these things are a huge component of the US economy. So, number one, the 75 basis point hike.
Number two, a less visible front, you can think of it as a flank, in this battle against inflation is quantitative easing. QE sounds like an esoteric subject, but in English, it’s pouring cash into the economy. The mechanism by which the Fed pours cash into the economy, is they actually buy bonds from the economy. When you buy a bond, say a million-dollar worth of bonds, you inject a million dollars into the bank who can now reloan that money. Now what’s happening is these bonds are being allowed to mature. They’re not being replaced, both in the European Central Bank and the US Fed are not buying bonds anymore. Not only are they not buying bonds anymore, but they’re also reducing the money supply by as much as $30 billion a month and intend to increase that number to $60 billion. Now a billion here, a billion there we’re starting to talk about real money here folks.
Item three, big shocker, probably already know this if you’ve got a pulse and have turned on a TV in the last week. The stock markets don’t like what’s going on. In this case more than ever before, literally since almost 1990. The Fed’s like we can’t help the markets. We’ve got to fight inflation. It’s one or the other. The markets are not enjoying the experience of not being underwritten anymore by the Fed. This is no great shocker. Anybody who’s been listening to my videos for the last year pretty much knew something had to give. Interest rates are the denominator in the valuation calculation that creates the value of stocks. In English, interest rates go up, all else is equal, stock valuations fall. This correction is not unexpected and arguably given valuations that’s overdue. Doesn’t make it any less unpleasant.
It is not a financial collapse. It is a traditional recession that’s being anticipated. Why do I bring this up? Because financial corrections like 2008 are far more damaging and far more risky to financial assets and to the economy as a whole. It’s something that’s got to be understood. In fact, the importance of fighting inflation is so that we don’t get into the territory where that is the risk.
What is inflation? Obviously, we know it’s the loss of purchasing power, but it’s really in many regards, a backdoor tax for when politicians were not willing to raise taxes, reduce spending. Maybe it’s fair to say, not willing or able. This isn’t all bad so long as it doesn’t get any higher because it has had the effect so far of monetizing fully 25% of the pandemic debt. Remember, everybody’s worried about all the money that was getting printed, how we’re going to pay for it. Well, guess what? We’ve already paid off a quarter through the mechanism of inflation. So, inflation is very much a backdoor tax.
But let’s keep this in perspective. If you look at polls, Americans are devastated in their reaction to what’s going on in the economy. And yet, if you look at the numbers, we are as close to full employment as we’ve ever been. We’re not quite where we were before the pandemic, but it’s historically remarkable how sturdy the economy is right now. In fact, that is one of the many drivers of inflation. That, supply chain, war, and energy, there are many components to this, not just the pandemic spending. It’s a perfect storm and it’s so easy to point fingers, but really, it’s almost a wasted exercise.
Item five that I want to talk about, what is it you do? What can we do? Nothing. I mean, that sounds awful, but right now, nothing. You should already be done. I know for our clients we’ve positioned the bonds at the short end of the curve. We’ve diversified, but there’s no way out of a storm. The only way through the storm is to batten down the hatches and be ready and we’re ready. In fact, there’s a silver lining to this and it’s a big one. For the last year and a half, we’ve been going, what do we do with these valuations? Where do we invest? Bonds pay nothing and can only get hurt. Stocks are so rich, where can they go?
Finally, it’s time to be able to consider increasing the market exposure of the remainder of the year. I’m not saying everybody jump in right now, but a plan for increasing exposure, if you’re throttled back, now’s the time. When there’s blood in the street is when the money’s made. Hang tight and with discipline now is the time to start considering sowing the seeds for the next market harvest.
So we know what the bad news is. We hear it every day in the news and every media outlet, on our phones, on social media. But there’s also good news and it’s very important. First and foremost, the US economy, unlike many others, is in rude health, it’s robust. Almost full employment. We’re in a good position to weather this. Even more important, there’s a global commitment in the United States, European Central Bank, almost every major bank except maybe Japan’s and they have their own deflation issues, have shown a willingness to come at inflation even if it’s at the cost of popularity in a recession. Frankly, it’s bittersweet, but I consider that to be great news. We wish you the best of investing success.
Caldwell, Preston. “Federal Reserve Gets Hawkish on Inflation.” Morningstar, Inc., 15 June 2022, https://www.morningstar.com/articles/1098575/federal-reserve-gets-hawkish-on-inflation.
Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.