Corporate finance columnist Les Nemethy examines the chances of the Fed pulling off a “soft landing” as it tries to balance the demands of the current rise in inflation and the potentially impending recession.
According to Bloomberg, the current decline in Nasdaq market capitalization has exceeded that of any recent crisis:
Internet bubble: $4.6 billion
Global financial crisis: $2.3 billion
COVID-19 liquidation: $4.4 billion
Current drop: 7.6 tln USD
And alongside the absolute numbers above, the state of the S&P 500 clearly shows that there is still plenty of room for further decline.
The rise in interest rates over the past month has caused an equally dramatic destruction of wealth in bond portfolios. It’s a rare occurrence in the financial world where the destruction of wealth is equally dramatic in bonds and stocks. “Nowhere to hide” seems to be the cry.
This value destruction is due to several factors: the ongoing war in Ukraine, the COVID-related lockdowns in China and, perhaps most importantly, the quantitative tightening (QT) program launched by the US Fed. Interest rates have risen significantly in recent weeks, with the Fed setting expectations for even more rate hikes.
While in previous crises the Fed has attempted to actively contain them, currently it appears to be proactively inducing the crisis. The Fed seems to view the destruction of value as the price to pay for controlling inflation (in other words, by cooling demand). This approach may not have been seen since Paul Volcker was Fed Chairman in 1980.
Although its actions have dragged financial markets down, the Fed is far from curing inflation, which is a stubborn beast. A monetarist economist would say that the more than 40% rise in M2 (a measure of money supply that includes cash, checking deposits and easily convertible quasi-currency) over the past two years will persist in causing a high inflation for at least the next year or two.
Even most Keynesian economists would say that extremely tight labor markets with rising wages, as well as supply-side bottlenecks (especially in energy and agriculture), are likely to cause high levels of inflation.
The question on every economist’s tongue is whether QT will induce another US recession or whether the US Fed can stage the proverbial “soft landing”. For now, consumer borrowing and spending in America remains strong (although these are still reported with a bit of a lag).
In my opinion, the landing could be very hard if the Fed continues with its inflation-fighting program, as inflation seems less sensitive to interest rate increases than economic activity, given the levels of record debt.
Current Federal Reserve Chairman Jerome Powell recently acknowledged that whether the United States achieves a soft landing is beyond the Fed’s control. It looks like the central bank itself is losing faith in a soft landing scenario.
Note in the chart below that over the past 20 years there has been a downward trend in peak interest rates reached before monetary easing is needed, attributable to rising debt levels. huge increase.
Rising interest rates are usually gradual, but when a crisis hits, the Fed tends to cut interest rates precipitously.
Statistics for the first quarter of 2022 in the United States showed nominal economic growth of -1.5%, while inflation increased to 8.5%. Stagflation is already here, in other words.
IMHO the most likely scenario is for the Fed to continue QT (maybe two or three more interest rate hikes, not the seven recently planned by the Fed) until something breaks or the Fed decides to pivot again.
Given record debt levels, rescuing the economy from the next crisis may require a quantitative easing (QE) scenario that eclipses the previous ones; another precipitous drop in interest rates, probably even into negative territory. This could trigger a broad rally in stocks and bonds.
It’s starting to look dangerously like what the influential Austrian economist Ludwig von Mises called a “crack-up” boom, which is followed by an even bigger crash.
“There is no way to avoid the final collapse of a boom caused by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as the final and total collapse of money itself,” as the said von Mises.
It appears that cooling inflationary forces would necessitate a QT of a magnitude that would induce a fairly severe recession, as the Fed is currently aiming for a “soft landing” and trying to avoid a recession.
Given the low pain threshold and the lack of political will to tolerate a recession, I think it’s more likely that the Fed will revert to QE at the first sign of a crisis, which means a recession can be avoided or only minor. The next Fed bailout may well come at the cost of unchecked inflation, and the bigger issue then becomes the credibility of the currency.
Disclaimer: This article is for educational (and hopefully entertainment) purposes only and should not be construed as investment advice. Investors should always obtain their own financial advice.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance company. He is a former global banker, author of Business Exit Planning (www.businessexitplanningbook.com) and former president of the American Chamber of Commerce in Hungary.
This article first appeared in the May 20, 2022 print issue of the Budapest Business Journal.