Addressing the remnants of prior decisions in light of current realities can be a challenging and often painful task. “If you commit the crime, you must serve the time.”
In the context of financial markets and the broader economy, these challenges can manifest in numerous ways, including but not limited to bankruptcies, closed businesses, and plummeting stock prices.
This week, Federal Reserve Chair Jay Powell and members of the Federal Open Market Committee (FOMC) made a significant move by raising the federal funds rate by 50 basis points. This marks the first such increase of this magnitude since 2000 and represents the Fed’s initial steps to address the issues stemming from past decisions.
The landscape has transformed drastically over the last 22 years, with economic and financial markets appearing increasingly chaotic. Without a clear perspective, even fundamental aspects like gas prices and housing costs seem bewildering and distorted.
The primary instigator of this turmoil is unquestionably the policies of quantitative easing (QE) and the zero interest rate policy (ZIRP) employed by the Fed. The current difficulties facing financial markets and the economy can be traced directly back to decades of Fed interventions aimed at artificially keeping interest rates low.
These ultra-low interest rates effectively “borrow from the future,” accelerating consumption while obscuring business failures. They disproportionately benefit risk-takers, leaving savers at a disadvantage.
Over the past 14 years, the Fed has increased its balance sheet by over $8 trillion, resulting in surging consumer price inflation. The official inflation rate, reflected in the consumer price index, currently sits at an annual rate of 8.5 percent—a peak not seen in 40 years. The unofficial inflation rate could be even higher, exceeding 17 percent.
Working-class individuals, savers, and those living on fixed incomes are feeling the brunt of these changes, while the affluent largely remain unscathed. The so-called “inflation tax” has eroded savings, diminished real wages, and lowered overall living standards for many.
So, what is causing this situation?
Raising Rates Amid a Recession
The Fed’s reliance on outdated data led to an excessively prolonged period of low interest rates, with consequences that are nothing short of disastrous.
Financial assets—including stocks, bonds, and real estate—have been inflated into enormous bubbles as a result, disproportionately benefiting wealthy asset holders.
However, what rises must eventually fall. The time of reckoning for these financial assets has only just begun.
For instance, the S&P 500 is experiencing its worst start to a year in 83 years, down 13.7 percent in the early months of 2022. To put this in perspective, in 1939, the S&P started the year down 17.3 percent, and in 1932 it fell by 28.2 percent. The NASDAQ has also plunged by approximately 20 percent, losing 13 percent just in April.
Additionally, the U.S. gross domestic product (GDP) contracted by 1.4 percent in the first quarter of 2022, indicating a possible recession. Official confirmation will not arrive until second-quarter GDP data is released, as a recession is typically defined by two consecutive quarters of GDP decline.
Meanwhile, the inflated bubbles in stocks, bonds, and real estate that the Fed has created are bound to deflate significantly. The stock market is on track for a bear market.
Importantly, the yield on 10-year Treasury bonds has doubled to about 3 percent in the last six months, and signs of a weakening real estate market are becoming evident.
Traditionally, bear markets and recessions emerge later in interest rate hiking cycles, not at the beginning. However, the Fed’s prolonged period of low rates, coupled with soaring consumer prices, has forced it to increase rates despite a struggling stock market and an economy in decline.
This is where the narrative turns intriguing…
Confronting Past Errors
The Fed’s failure to recognize the steep climb in consumer price inflation until it spiraled out of control has left it with a substantial challenge. Currently, it appears ill-equipped to manage the situation.
The Fed is significantly lagging in its response, indicating it may need to raise rates much more aggressively than many anticipate—even amidst a full-blown economic downturn.
When evaluating Fed policy, it’s crucial to consider not just the federal funds rate but also how it stacks up against inflation. If inflation continues to escalate faster than interest rates, the Fed’s policies remain essentially inflationary.
In March, the Fed raised the federal funds rate by 0.25 percent. This week saw another increase of 0.5 percent, bringing the target range to 0.75 to 1 percent. Yet, the consumer price index increased by 1.2 percent in March alone (with April’s figures forthcoming).
Thus, while the Fed has raised rates by 0.75 percent since March, it is still falling behind the inflation curve. This precarious position is bound to worsen as the economy stagnates while inflation surges.
If the Fed were genuinely serious about curbing inflation, it should have enacted a rate hike of at least 1.5 percent this week. Despite this, Wall Street reacted positively, leading to a 3 percent surge in both the S&P 500 and NASDAQ following the FOMC announcement on Wednesday.
However, this period of stock market exuberance was fleeting. The following day, the S&P 500 dropped by 3.5 percent, and the NASDAQ fell nearly 5 percent.
The belief that the Fed can tame inflation without triggering a recession is nothing more than wishful thinking. The repercussions of past policies are significant.
Ultimately, there’s no escaping the need to reckon with the consequences of past actions. And here’s a crucial point: you may end up bearing the cost.
Sincerely,
MN Gordon
for Economic Prism
Return from Settling Wreckage from the Past to Economic Prism
