The Fed Is Fighting a Two-Front War

The Federal Reserve is fighting simultaneously for both price stability and financial stability.

Because the Fed pumped too much money into the economy in the years before 2022, high inflation became self-sustaining, causing the Fed in 2022 to engage in perhaps its fastest and most aggressive monetary tightening ever. Negative effects of the tightening are spreading through the economy.

As some analysts express it, “Things are breaking.”

As I’ve said before, the effects of monetary policy changes aren’t immediate or uniform. Some sectors of the economy and markets show the effects first. The effects gradually spread through most of the economy before the Fed begins to loosen policy again.

Most of the bubbles that inflated during the pandemic were the first to burst, such as highly leveraged sectors and those that depended on having a lot of liquidity in the economy. Leading the way down were technology companies, digital currencies, housing, startup companies and stocks with high valuations.

More recently, the damage spread to commercial real estate and the banking system.

Some sectors of commercial real estate are doing fine, but recently a few major office building owners defaulted on debt backed by Class A properties.

The runs on mid-size and small banks have been well-publicized. The troubles were direct consequences of bankers responding to the monetary expansion of 2020 and 2021 and not reversing those actions when the Fed contracted the money supply.

The good news is that, at this point, none of the troubled sectors poses a systemic risk to the economy or financial system. The bad news is the damage isn’t over. The Fed’s not done tightening and probably is a long way from reducing interest rates and expanding the money supply. It is likely, though, that the Fed is close to pausing its tightening.

Despite problems in some sectors of the economy, many sectors remain strong. The Fed can’t reverse monetary policy until there are more and substantial signs that inflation is moving faster to the 2% target, or the economy is weakening enough to expect inflation to tumble.

We’re not at that point, and it isn’t in sight. The labor market remains strong, with a lot of job openings, low unemployment and wage increases above the 10-year average.

The service sector, which is about 70% of the economy, continues to grow.

The Fed is in a quandary. It can’t tighten much more because that would cause more problems for banks. It can’t loosen to help banks because that would spur economic growth and inflation.

Investors are making the Fed’s job more difficult. When market optimism causes stock prices to increase and interest rates to decline, consumer confidence increases and supports more spending and economic growth, which in turn supports inflation.

Economic growth and incomes must decline more for inflation to fall to the Fed’s target. Historically, the amount of tightening the Fed executed in 2022 would have caused sharp declines in the economy and inflation. But there were re-enforcing factors in the economy that sustained both growth and inflation.

Because of the banking sector problems, the Fed is likely to pause its tightening and hold policy steady. The Fed will engage in watchful waiting before deciding its next policy move.

The markets seem to expect otherwise. They’re looking for the Fed to loosen soon, and I believe they are too optimistic.

I anticipate earnings and profit margins to decline at more companies. More banks are likely to have problems, and defaults are probable in high-yield bonds and bank loans.

It is still a good time to have low allocations to stocks and bonds. Own some funds that can sell short major markets. And yields of 5% or so in money market funds look very attractive.