The Fed’s Tighter Policies Are Starting to Bite

As the economy continues to generate positive economic data, investors should ponder what will happen when the one-time factors supporting the markets and economy fade.

The Federal Reserve started to tighten monetary policy in 2015, but the economy continues to grow. That’s partly because it usually takes two years or so for a change in monetary policy to be felt in the economy.

But it’s also because one-time factors offset the tightening. Deregulation and the corporate tax cuts enacted in late 2017 boosted growth. The tax changes reduced tax bills for many businesses and enabled corporations to bring accumulated overseas profits into the United States at a low tax cost.

Corporations also are responding to recent growth by increasing their capital investments. The recent strength of the dollar helps the U.S. economy by attracting more investment money to the United States.

Tighter monetary policy pinches financial markets first, and we’ve seen that in action. Stocks haven’t returned to January’s highs, and volatility has increased after years of stability. Bonds generally have negative returns for 2018. The strongest effects of tighter monetary policy have been felt overseas with sharp drops in foreign currencies, stocks and bonds. Vulnerabilities in Italy and some emerging markets were revealed quickly.

Don’t believe the recent market troubles are all the result of trade conflicts. The recent changes in the markets and economy are typical of what happens after the central bank tightens policy. In addition,
late in the business cycle investors begin to react strongly to surprising news. When the Fed’s easy monetary policy was supporting markets, that news either was ignored or the reactions were short
term. Now, investors react to headlines.

The U.S. economy is showing some of the first effects of tightening. We’ve seen slower growth in retail
sales and household borrowing. Housing has been up and down in the first half of the year. Consumer confidence surveys still are very positive but reveal less optimism beyond the next six months.

The economy should be in good shape for at least the rest of 2018 because of the factors already in place. It is unclear what will happen when the boost from fiscal stimulus fades and stops offsetting the Fed’s policies.

The economy’s fundamentals are strong, and the financial institutions are healthy. We don’t have the high inflation and widespread excesses that are typical of the last stage of the investment cycle. Those are some reasons why I’m not expecting a crash similar to 2008. We might not even have a real recession. We could have gradual weakness in the economy and markets followed by a long, flat period.

But once a slowdown begins, it could be tough to boost growth. The Fed doesn’t have too many tools left to boost the economy. There also aren’t a lot of options for fiscal stimulus.

Weak returns are likely from the investments that have done well in recent years. Short-term interest rates have increased significantly since late 2017, making cash a reasonable investment alternative again. That puts pressure on riskier investments.

Financial engineering by corporations provided a lot of support for stocks through stock buybacks, mergers and dividend increases. That support is likely to fade as the one-time benefits of the tax cut fade.

The main risk to investors remains that the Fed might tighten too much. Historically, the Fed tightens until after a recession begins. The Fed could be more cautious this time because it knows the economy is fragile and it has fewer tools than usual to reverse a downturn. The key will be what the Fed does as the effects of fiscal stimulus fade. I hope the Fed realizes that its actions affect the economy with a significant lag, so it will act cautiously instead of continuing to tighten.