The Fed Continues to Deflate the Bubbles

Will we experience another 2018?

Markets are betting that we will, but they ignore important differences between then and now. The Federal Reserve gradually began reversing its extraordinary monetary policies from the financial crisis in 2015. In 2018, the Fed raised interest rates and withdrew liquidity from the economy. The effects were sudden and significant. The economy quickly slowed, and stock indexes sank.

The S&P 500 had its worst December since the Depression. The index finished the year down 4.5%, despite being up 9% after the first three quarters.

The Fed hurriedly reversed course. Both the economy and markets bounced back until the pandemic hit in early 2020. Futures markets are betting the same sequence of events is likely in 2022. The markets indicate inflation will return to around 2% after the Fed engages in the shortest and least aggressive tightening in its history.

But this isn’t 2018. The economy is much stronger today, and much of the recent growth looks sustainable. Household incomes are high and rising, though they aren’t increasing enough to keep up with inflation. The worker shortage makes it likely that compensation will continue to rise and keep pushing prices higher.

Only some of today’s supply problems are temporary or due to the pandemic. Most of the supply shortage is because of very strong demand that’s likely to be sustained. Inventories are at historic lows, and it will take suppliers quite a while to increase capacity enough to match demand.

Also, the Fed is going to be more tolerant of falling stock prices in 2022, which Fed Chairman Jerome Pow- ell made clear in his comments after the January Fed Open Market Committee. Some sectors of the stock market and other investments benefited more than others from the liquidity the Fed pumped into the economy. These markets reached high valuations, and some reached bubble territory. Though the Fed has made very modest policy changes so far, markets already pushed interest rates higher.

That caused price bubbles in some stocks and other assets to begin deflating. Take a look at the Ark Innovation ETF (ARKK). It was priced above $120 in early November, but in February, it fell below $70. Bitcoin has lost close to half its value since early November. There are dozens of other examples.

Stocks and bonds are losing value at the same time, which hasn’t been the case for a while. It’s a sign of liquidity leaving the markets. Investment prices are deflating. So far, the Fed is fine with that. Interest rates on U.S. bonds have a lot of room to rise before reaching levels that were normal before the financial crisis. That would reduce bond prices.

Prices of highly valued stocks also have a lot of room to decline. Unlike in 2018, the Fed will tolerate declining asset prices until they appear to weigh on economic growth. Interest rates aren’t the Fed’s real tools to control inflation. Investors already anticipated Fed moves and increased market interest rates ahead of Fed action. So far, the Fed has only stopped injecting new liquidity into the economy and markets. It hasn’t really tightened.

The Fed’s real influence will be felt when it decreases its balance sheet by selling assets it purchased after the pandemic or doesn’t replace bonds and mortgages as they mature. This is known as quantitative tightening and takes liquidity out of the economy and markets faster than raising rates.

Economic growth will continue even as the Fed slowly removes liquidity. But even the prospect of tightening is negative for many U.S. stocks, other risky assets and bonds. It is more important than it has been in years to have solid diversification and hold assets that have good mar- gins of safety.