“Just because inflation was no higher than economists had forecast at 7% year-on-year for December does not mean that investors or central bankers can relax. The last time inflation was this high in the USA, back in summer 1982, the effective Federal Reserve Funds Rate stood at north of 14%,” says AJ Bell Investment Director Russ Mould. “Nor was the central bank running a balance sheet that has doubled in size in two years and grown by a factor of ten over the last twelve years, thanks to Quantitative Easing policies designed to fight the Great Financial Crisis and the pandemic, among other things.
Source: FRED – St. Louis Federal Reserve database
“In that context, any notions that current Fed chair Jay Powell is talking or acting tough when it comes to inflation seem entirely fanciful. In real – post-inflation – terms, the effective Fed Funds Rate has never been lower.
Source: FRED – St. Louis Federal Reserve database
“Then there’s the issue of the $8.8 trillion balance sheet again, thanks to QE.
“Taking these at face value, the Fed has massively overstimulated the economy, partly in fear of what the pandemic may have done, and it has now begun to reap the whirlwind.
“Matters are not quite that simple. In 1982, the Paul Volcker-led Fed was in the process of bringing interest rates down as it squeezed inflation out of the system (albeit at the expense of a very nasty recession).
“Moreover, Federal, corporate and consumer debts are so much higher than they were 40 years ago, so it will surely not take anything like the monetary medicine dished out by Volcker to choke off the US economy.
“The Powell-led Fed therefore has an even more difficult balancing act, as it seeks to drive down unemployment on one hand and keep a lid on inflation with the other.
“And Mr. Powell does not have to go back to 1982 to see the damage that tighter monetary policy can do.
“Even just talk of a tapering of QE prompted a stock market wobble back in 2013, as the Yellen-Fed then had to back off and tackle the so-called Taper Tantrum.
“And Ms. Yellen and then Mr. Powell did not get very far with tightening policy between 2015 and 2018 before they had to back off, as the US economy slowed, the plumbing of the financial markets began to clog and strains began to show in the interbank funding markets once more, as evidenced by autumn 2019’s spike in repo funding rates between banks.
“The Fed managed to slowly take interest rates from 0.25% to 2.50% between December 2015 and December 2018. It also shrank its balance sheet by $700 billion (or 17%) down to $3.8 trillion by June 2019 before things began to wobble.
“The central had actually started to expand its balance sheet again in autumn 2019, albeit very gradually, some months before the pandemic hit and the Fed dashed to press the ‘print’ button once more.
Source: FRED – St. Louis Federal Reserve database
“Markets may seem relaxed right now by the prospect of three or four interest rate rises in 2022 and some Quantitative Tightening but if Mr Powell and the Federal Open Markets Committee keep acting, it may not take long before the debate switches to the number of hikes and degree of QT that it takes for the economy to slow and financial markets to start creaking once more.
“It did not take much in 2015-2018, despite the Fed’s softly-softly approach and there is more debt around now than there was back even just a few years ago.”
