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You’ve got to hand it to the Federal Reserve...

March 24, 2021
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You’ve got to hand it to the Federal Reserve. With the cleverness of a seasoned head coach – think Jim Boeheim leading Syracuse in the NCAA basketball tournament – they figured out how to accomplish a great deal while making it look like they didn’t have many tools at their disposal. The market keeps expecting the Fed to bow to pressures to lift rates, and the Fed knows that it can’t keep interest rates at zero forever. But it wants to keep them there for as long as it can.

So, how do they do that? Well, one way is to forecast higher inflation and real GDP growth so that if (and when) it occurs, you can say “well, that doesn’t surprise us at all.” Follow the bouncing ball. At its last meeting, the Fed raised its 2021 real GDP forecast to 6.5% growth, while it expects 2.4% inflation (and argues that it wants inflation to rise above 2%), and unemployment is forecast to fall below 4% in 2022.

Despite that outlook, most Fed members are still projecting no increases in short-term interest rates until 2024 or beyond. As a result, the economy can accelerate to its fastest growth rate since the early 1980s and inflation can move above the Fed’s 2% target, all while the Fed sits back and yawns.

Of course, the bond market has a say in things, too. Rapid growth and higher inflation could push up long-term interest rates even further, and at that point, the “bond vigilantes” may force the Fed’s hand. But the Fed feels confident that it has the tools to deal with this…specifically, asset purchases. Right now, the Fed is buying $80 billion of Treasury debt each month and $40 billion of mortgage-backed securities. When they buy bonds, they are essentially printing money. When the US owns its own debt, the impact of interest rates rising is reduced.

Good for the economy? Maybe. Good for the economy long term? No!

The Fed could raise the total every month, it could shift purchases to longer-dated Treasury debt, or it could buy fewer mortgages and more Treasuries. After all, the housing market is booming, so the Fed can withdraw support. We think, in the end, the Fed will change its mix of bond-buying and be pressured to lift rates before it now expects.

Bottom line is that the Fed is doing exactly what Congress is doing: diluting future purchasing power. By flooding money into the system, you create economic growth and inflation, but since this is make-believe money, not earned, it creates future liability. That liability eventually needs to be paid back and will eventually create a weaker dollar and high inflation.

When the Federal Government spends money, and the Fed pays for it by printing new money, it expands the private banking system in the United States. And if banks eventually hit these new liquidity rule levels, they must stop accepting deposits, stop making business loans, or stop buying Treasuries. The fear that banks may stop buying Treasuries caused a jump in longer-term interest rates last week (the 10-year Treasury jumped to over 1.7%). At the same time, bank stock prices fell. It’s simple math. If these banks are forced to hold more capital, then returns to shareholders will fall as they stop buybacks, limit dividends, or even issue more shares. We think all this was a short-term over-reaction.

But, remember, the government just passed another $1.9 trillion “rescue” bill which must be financed by borrowing, and the Fed is scheduled to buy $1.4 trillion in assets this year. On top of this, team Biden is saying it wants to pass another $2 trillion to $4 trillion infrastructure bill. And while this is going on, we expect real GDP to expand by 6% this year, which will certainly increase the demand for business loans.

In other words, as the future unfolds, the cushion of capital will be absorbed. Banks have said they face no near-term problems and we don’t disagree. Lending can continue as the economy picks up. Progressives want to revert to a national bank or have regulators gain even more control over the private banking system than they already have.

The US has entered an unprecedented period of government regulation and growth. Former Clinton Treasury Secretary Larry Summers has called it “the least responsible fiscal macroeconomic policy we’ve had for the last 40 years.” We think he is right about irresponsibility but wrong about the time period. It’s not the past 40 years, it’s the entire history of the United States. In the near-term, investors are safe from the stagflation we saw 40 years ago. What is stagflation? Persistent high inflation combined with high unemployment and stagnant demand in a country's economy. I am not so sure that it won’t rear its head by 2023. Stay positive for now, the worries are long-term and I will always keep you invested relative to the current environment.

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