Fed hikes now, pain comes later

Fed Chairman Jerome Powell announced a 75 basis point increase in the Fed funds target rate at his post-FOMC press conference today:

“Today, the FOMC raised our policy interest rate by 75 basis points, and we continue to anticipate that ongoing increases will be appropriate. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. In addition, we are continuing the process of significantly reducing the size of our balance sheet. Restoring price stability will likely require maintaining a restrictive stance of policy for some time.”

The target range is now 3.75% to 4.0%.

Fed Funds Rate

Commenting on today’s announcement, Michael Contopoulos from Richard Bernstein says little has changed:

“Nothing really changed today, the Fed has been hawkish since Jackson Hole. It doesn’t matter how high rates go, what matters is that the Fed is going to be restrictive and they’re going to bring down long-term growth…..The end game is not cutting rates, at least any time soon, the end game is to slow growth and slow the economy.” (CNBC)

Chris Brightman from Research Affiliates, co-manager several PIMCO funds, offers a useful rule-of-thumb as to how far the Fed will need to hike. The unemployment rate has to rise by 1.0% for every 1.0% intended drop in core inflation.

Core inflation is close to 6.0% at present, if we take the average of core CPI (purple), growth in average hourly earnings (pink), and core PCE index (gray). To achieve the Fed’s 2.0% inflation target, using the above rule-of-thumb, would require a 4.0% increase in the unemployment rate.

Unemployment

That means an unemployment rate of 7.5% (red line below), making a recession almost certain.

Unemployment Rate

The recent 10-year/3-month Treasury yield inversion also warns of a recession in 2023.

Treasury 10-Year minus 3-Month Yield

Conclusion

We expect the Fed to hike the funds rate to between 5.0% and 6.0% — the futures market reflects a peak of 5.1% in May ’23 — then a pause to assess the impact on the labor market. Employment tends to lag monetary policy by 6 to 12 months, so the results of recent rate hikes are only likely to show in 2023. The recent inversion of 10-year and 3-month Treasury yields also warns of a recession next year.

The unemployment rate will most likely need to rise to 7.5% to bring inflation back within the Fed’s target range. That would cause a deep recession, especially if the Fed holds rates high for an extended period as they have indicated.

Uncertainty still surrounds whether the Fed will be able to execute its stated plan. A sharp rise in unemployment or bond market collapse could cause an early Fed pivot as the Treasury yield curve and Fed fund futures still expect.

Treasury Yield Curve & Fed Funds Rate Futures

Bond market: No place to hide

Advance retail sales were flat in September, reflecting slowing growth, but remain well above their pre-pandemic trend. So far, Fed rate hikes have failed to make a dent in consumer spending.

Advance Retail Sales

Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.

Advance Real Retail Sales

The culprit is M2 money supply. While M2 has stopped growing, there has been no real contraction to bring money supply in line with the long-term trend. A fall of that magnitude would have a devastating effect on inflated asset prices.

M2 excluding Time Deposits

Inflation is proving persistent, with CPI hardly budging in September. Hourly earnings growth is slowing but remains a long way above the Fed’s 2.0% inflation target.

CPI & Hourly Earnings Growth

Treasury yields have broken their forty year down-trend, with the 10-year testing resistance at 4.0%. Stubborn inflation is expected to lift yields even higher.

10-Year Treasury Yield

Inflation is forcing the Fed to raise interest rates, ending the forty-year expansion in debt levels (relative to GDP). Cheap debt supports elevated asset prices, so a decline in debt levels would cause a similar decline in asset prices.

Non-Financial Debt/GDP

A decline of that magnitude is likely to involve more pain than the political establishment can bear, leaving yield curve control (YCC) as the only viable alternative. The Fed would act as buyer of last resort for federal debt, while suppressing long-term yields. The same playbook was used in the 1950s and ’60s to drive down the debt to GDP ratio, allowing rapid growth in GDP while inflation eroded the real value of public debt.

Federal Debt/GDP

Conclusion

We are fast approaching a turning point, where the Fed cannot hike rates further without collapsing the bond market. In the short-term, while asset prices fall, cash is king. But in the long-term investors should beware of financial securities because inflation is expected to eat your lunch. Our strategy is to invest in real assets, including gold, critical materials and defensive stocks.

Will a recession kill inflation?

There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.

MacroAlf: CPI & Recessions

A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.

CPI, Average Hourly Earnings & Recessions

Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.

Fed Funds Rate & Unemployment

In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.

A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.

Unemployment(U3) & Average Hourly Earnings Growth

Conclusion

We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:

(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).

An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.

A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.

The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.

Federal Debt/GDP

Acknowledgements

Alfonso Peccatiello for his analysis of CPI and recessions.

CPI shock upsets markets

The consumer price index (CPI) dipped to 8.25% (seasonally adjusted) for the 12 months to August but disappointed stock and bond markets who were anticipating a sharp fall.

CPI

The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.

S&P 500

Services CPI — which has minimal exposure to producer prices and supply chains — climbed to 6.08%. Rising services costs indicate that inflation is growing embedded in the economy.

CPI Services

Fueled by strong growth in average hourly earnings.

CPI & Wage Rates

But it is not only services that present a problem.

Food prices are growing above 10% p.a. — signaling hardship for low income-earners.

CPI Food

The heavily-weighted shelter component — almost one-third of total CPI — climbed to 6.25%. We expect further increases as CPI shelter lags actual home prices — represented by the Case-Shiller 20-City Composite Home Price Index (pink) on the chart below — by 6 to 12 months.

CPI Shelter

CPI energy is still high, at 23.91% for the 12 months to August, but the index has fallen steeply over the past two months (July-August).

CPI Energy

The decline is likely to continue until the mid-term elections in November, as the US government releases crude from its strategic reserves (SPR) in order to suppress fuel prices.

SPR Levels

The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.

SPR Lowest since 1984

Conclusion

Strong CPI growth for the 12-months to August warns that inflation will be difficult to contain. Services CPI at 6.08% also confirms that inflation is growing embedded in the economy.

Energy costs are falling but this may be unsustainable. Releases from the strategic petroleum reserve (SPR) are likely to end after the mid-term elections in November.

The Fed is way behind the curve, with the real Fed funds rate (FFR-CPI) at -5.92%, below the previous record low of -4.97% from 1975.

Real Fed Funds Rate (FFR-CPI)

We expect interest rates to rise “higher for longer.” A 75 basis-point hike is almost certain at next weeks’ FOMC meeting (September 20-21).

Long-term Treasury yields are rising, with the 10-year at 3.42%. Breakout above resistance at 3.50% is likely, signaling the end of a four decade-long secular bull trend in bonds.

10-Year Treasury Yields

Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.

S&P 500 and iShares 20+ Year Treasury ETF (TLT)

The best short-term haven is cash.

Putin’s war

“The economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets”.

Vladimir Putin gave some insight, last week, into his strategy to force Europe to withdraw its support for Ukraine. It involves two steps:

  1. Use energy shortages to drive up inflation;
  2. Use inflation to undermine confidence in the Euro and Dollar.

Will Putin succeed?

There are plenty of signs that Europe is experiencing economic distress.

When asked whether he expected a wave of bankruptcies at the end of winter, Robert Habeck, the German Federal Minister for Economic Affairs and Climate Action, replied:

Robert Habeck

Belgian PM Alexander De Croo also did not pull his punches:

“A few weeks like this and the European economy will just go into a full stop. The risk of that is de-industrialization and severe risk of fundamental social unrest.” (Twitter)

Steel plants are shutting down blast furnaces as rising energy prices make the cost of steel prohibitive. This is likely to have a domino effect on heavy industry and auto-manufacturers.

Europe: Steel Production

Aluminium smelters face similar challenges from rising energy costs.

Europe: Aluminium

How is the West responding?

Europe is reverting to coal to generate base-load power.

German Coal

And increasing shipments of LNG. Germany is building regasification plants and has leased floating LNG terminals but there are still bottlenecks as the network is not designed around receiving gas from Russia in the East, not ports in the West.

Europe LNG

Also, extending the life of nuclear power plants which were scheduled to be mothballed.

The new British prime minister, Liz Truss, is going further by lifting the ban on fracking. But new gas fields and related infrastructure will take years to build.

The President of the EC, Ursula von der Leyen’s announcement of increased investment in renewables will also be of little help. It takes about 7 years to build an offshore wind farm and the infrastructure to connect it to the grid.

Energy subsidies announced are likely to maintain current demand for energy instead of reducing it. A form of government stimulus, subsidies are also expected to increase inflation.

Price cap

The G7 has also responded by announcing a price cap on Russian oil. The hope is that the Russians will be forced to keep pumping but at a reduced price, avoiding the shortages likely under a full embargo.

Vladimir Putin, however, will try to create an energy crisis in an attempt to break Western resolve.

Russian Oil

Putin responded to the price cap at the Asian Economic Forum, on Wednesday, in Vladivostok:

“Russia is coping with the economic, financial and technological aggression of the West. I’m talking about aggression. There’s no other word for it…….

We will not supply anything at all if it is contrary to our interests, in this case economic. No gas, no oil, no coal, no fuel oil, nothing.”

Ed Morse at Citi has expressed concerns about the price cap, calling it “a poor judgement call as to timing.” His concerns focus on the political implications of Winter hardship in Europe, especially with upcoming elections in Italy, the potential effect of lower flows out of Russia, and the impact increased demand for US oil would have on domestic prices.

The Dollar

Attempts to undermine the Dollar have so far failed, with the Dollar Index climbing steadily as the Fed hikes interest rates.

Dollar Index

While Gold has fallen.

Spot Gold

Conclusion

The West is engaged in an economic war with Russia, while China and India sit on the sidelines. War typically results in massive fiscal deficits and soaring government debt, followed by high inflation and suppression of bond yields.

We expect high inflation caused by (1) energy shortages; and (2) government actions to alleviate hardships which threaten political upheaval.

The Fed and ECB are hiking interest rates to protect their currencies but that is likely to aggravate economic hardship and increase the need for government spending to alleviate political blow-back.

We maintain our bullish long-term view on Gold. Apart from its status as a safe haven — especially when the Dollar and Euro are under attack — we expect negative real interest rates to boost demand for Gold as a hedge against inflation. In the short-term, breach of support at $1700 per ounce would be bearish, while recovery above the descending trendline (above) would signal that a base is forming. Follow-through above $1800 would signal another test of resistance at $2000.

Acknowledgements

Brookings Institution: Discussion on the Price Cap
FT Energy Source: How Putin held Europe hostage over energy
Alfonso Peccatiello: Putin vs Europe – The Long War
Andreas Steno Larsen: What on earth is going on in European electricity markets?

Base case: global recession

The Treasury yield curve is flattening, with the 10-year/3-month yield differential plunging sharply, to a current 0.24%. Another 75 basis point rate hike at the next FOMC meeting is expected to drive the 3-month T-Bill discount rate above the 10-year yield, the negative spread warning of a deep recession in the next 6 to 18 months (subsequent reversal to a positive spread would signal that recession is imminent).

10-Year & minus 3-Month Treasury Yield

The S&P 500 is retracing to test short-term support at 4200. Breach would warn of another decline, while follow-through below 3650 would signal the second downward leg of a bear market.

S&P 500

 

21-Day Volatility troughs above 1% (red arrows) continue to warn of elevated risk.

S&P 500

Dow Jones Industrial Metals Index is in a primary down-trend, warning of a global recession.

DJ Industrial Metals Index

Supported by a similar primary down-trend on Copper, the most prescient of base metals.

Copper

Brent crude below $100 also warns of an economic contraction. Goldman Sachs project that crude oil will reach $135 per barrel this Winter, while Ed Morse at Citi says that WTI Light Crude will likely remain below $90 per barrel. Obviously, the former foresees an economic recovery, while the latter sees an extended contraction. Of the two, Morse has the best track in the industry.

Brent Crude

Natural gas prices are climbing.

Natural Gas

Especially in Europe, where Russia is attempting to choke the European economy.

Russia: EU Gas

Causing Germany’s producer price index to spike to 37.2% (year-on-year growth).

EU: PPI

Conclusion

Our base case is a global recession. A soft landing is unlikely unless the Fed does a sharp pivot, Russia stops trying to throttle European gas, and China goes all-in on its beleaguered property sector. That won’t address any of the underlying problems but would kick the can down the road for another year or two.

In the Ways That Count, Liz Cheney Won | Frank Bruni

Liz Cheney

Extract from Frank Bruni’s piece in the New York Times:

I know what the numbers say. I can read the returns. By those hard, cold, simplistic measures, Liz Cheney was defeated overwhelmingly in her House Republican primary in Wyoming on Tuesday night, and her time in Congress is winding down.

But it’s impossible for me to say that she lost.

She got many, many fewer votes than her opponent, an unscrupulous shape shifter unfit to shine her shoes, because she chose the tough world of truth over Donald Trump’s underworld of lies. That’s a moral victory.

She was spurned by conservatives in Wyoming because she had the clear-eyed vision to see Trump for what he is and — unlike Mitch McConnell and Kevin McCarthy, whose titles perversely include the word “leader” — she wouldn’t don a blindfold. That makes her a champion in the ways that count most.

Come January, she will no longer be Representative Cheney because she represents steadfast principle in an era with a devastating deficit of it. History will smile on her for that. It will remember the likes of McConnell and McCarthy for different, darker reasons. You tell me who’s the winner in this crowd…..

Conclusion

We try to stay out of party politics but Liz Cheney’s stand is about principle — the preservation of American democracy — which should be above politics. Sadly, that is no longer the case.

Related articles

Retired Admiral James Stavridis | Setting fire to the Wells – November 19, 2020
George Orwell | The appeal of Fascism – November 11, 2020
The Threat to Global Democracy – August 18, 2022
Thomas Homer-Dixon: The American polity is cracked, and might collapse. Canada must prepare, The Globe & Mail – January 2, 2022

Fiona Hill | Putin is pushing our buttons

British-born Fiona Hill is an expert on Russia and Vladimir Putin and served as security adviser to US Presidents George W. Bush, Barack Obama and Donald Trump. Her take on Russia’s invasion of Ukraine is that Vladimir Putin still thinks he is winning. The Kremlin has a far higher tolerance for troop losses than Western governments and Putin believes that he can grind out a victory of sorts. He thinks he has the upper hand in terms of leverage, through his influence on energy markets and food shortages, and is prepared to wait out the West — waiting for them to lose patience and attempt to force a negotiated settlement.

“Putin is a contingency planner. If one thing doesn’t work, he’ll try another. If things get dire, expect more nuclear sabre-rattling. They already rhetorically deployed nuclear weapons, and used them, on national television.

Bear in mind they take a very careful read of us and how we react. Think about when they moved through the Chernobyl exclusion zone into Ukraine….People said they wouldn’t possibly do that but they did. This scares the heck out of everyone….Same thing with Zaporizhzhia nuclear power plant. They deliberately shelled it. Think about the timing. It was just when Germany and Japan were considering recommissioning their nuclear power plants. All this happens because Putin knows he can push our buttons. He knows our fears and can play to those fears.”

The West has to get ahead of this. But we always tend to do things too late. Earlier action in Ukraine — in terms of supplying weapons — may have deterred Putin.

“Putin and the Kremlin have a major advantage: continuity. They have been in power for a long time and have no effective opposition.

The West, by contrast, has no continuity. This is the main obstacle to getting ahead of the game. Democracies tend to lose focus over time…..The more domestic problems you have, the more likely you are to lose focus.

….Putin’s business is to find points of leverage.

Political donations. Corruption. Germany’s pact with the devil — it’s economy is built on reliance on cheap Russian gas. We have to wind this all back.

Jay Powell is selling but the bond market isn’t buying

Fed Chairman Jerome Powell declared that the Fed’s commitment to taming inflation is “unconditional”:

June 23 (Reuters) – The Federal Reserve’s commitment to reining in 40-year-high inflation is “unconditional,” Powell told lawmakers on Thursday, even as he acknowledged that sharply higher interest rates may push up unemployment.

“We really need to restore price stability … because without that we’re not going to be able to have a sustained period of maximum employment where the benefits are spread very widely,” the Fed Chairman told the U.S. House of Representatives Financial Services Committee.

Under questioning by members of the House panel on Thursday, Powell said there was a risk the Fed’s actions could lead to a rise in unemployment. “We don’t have precision tools,” he said, “so there is a risk that unemployment would move up, from what is historically a low level though. A labor market with 4.1% or 4.3% unemployment is still a very strong labor market.”

He also dismissed cutting interest rates if unemployment were to rise while inflation remained high. “We can’t fail on this: we really have to get inflation down to 2%,” he said.

The Fed chief was also asked about the central bank’s balance sheet, which was built up to around $9 trillion during the pandemic in an effort to ease financial conditions and is now being pared. The Fed aims to get it “roughly in the range of $2.5 or $3 trillion smaller than it is now,” Powell said.

But the bond market isn’t buying it. Treasury yields from 2-year to 30-year are compressed in a narrow band above 3%, indicating a flat yield curve. Expectations are that the Fed can’t go much higher than 3.0% to 3.5%.

Treasury Yield Curve

The dot plot from the last FOMC meeting similarly projects a 3.4% fed funds rate by the end of 2022, 3.8% by 2023, and lower at 3.4% by the end of 2024.

FOMC Dot Plot

You cannot cure inflation with a Fed funds rate (FFR) of 3.5%.

CPI is growing at 8.6% YoY, while the FFR target maximum is 1.75%. Another 1.75% just won’t cut it. You have to hike rates above inflation. Positive real interest rates are the best antidote for inflation but the economy, in its current precarious state, could not withstand this.

Fed Funds Rate & CPI

Taming inflation in the 1980s

Paul Volcker killed inflation by hiking the fed funds rate to 20% in 1980, but we live in a different world.

In 1980, federal debt to GDP was less than 50% of GDP. Today it’s 118%.

Federal Debt/GDP

The Federal deficit was 2.5% of GDP. Now it’s 12%.

Federal Deficit/GDP

Private debt (excluding the financial sector) was 1.35 times GDP in 1980. Now it’s more than double.

Private Non-Financial Debt/GDP

Powell can’t hike rates like Volcker. If he tried, he would collapse the economy and the US Treasury would be forced to default on its debt. Collapse of the global reserve asset is about as close as you can get to financial Armageddon.

Pricking the bubble

Instead, the Fed plans to use QT to deflate the asset bubbles in stocks and housing, in the hope that a reverse wealth effect — as households feel poorer — will slow consumer spending and reduce inflation.

So far, the S&P 500 has dropped by 25% and the housing market is likely to follow. The 30-year mortgage rate has climbed to 5.81%, more than double the rate in August last year.

30-Year Fixed Mortgage Rate

Housing starts and permits are both declining.

Housing Starts & Permits

Powell talks of a $2.5 to $3.0 trillion reduction in the Fed’s balance sheet. That would increase the supply of Treasuries and MBS in financial markets by an equivalent amount which would be sucked out of the stock market, causing a fall in prices.

The two largest foreign investors in US Treasuries — Japan and China — have also both become net sellers to support their currencies against the rising Dollar. That will further increase the supply of Treasuries, causing an outflow from stocks.

Since 2009, stock market capitalization increased by $47.4 trillion, from $16.9T to $64.3T at the end of Q1. At the same time, the Fed’s balance sheet increased by $7.9 trillion, from $0.9T to $8.8T. Market cap increased by $6T for every $1T increase in the Fed’s balance sheet (QE). The multiplier effect is 6 times (47.4/7.9).

Stock Market Capitalization & Fed Total Assets

If the Fed were to shrink its balance sheet by $2.5 trillion and net foreign sales  of Treasuries amount to another $0.5 trillion, we could expect a similar multiplier effect to cause an $18 trillion fall in market capitalization ($3Tx6). Market cap would fall to $50T or 26.5% from its $68T peak in Q4 of 2021.

That’s just the start.

“Inflation is always and everywhere a monetary phenomenon”

Nobel prize-winner Milton Friedman argued that long-term increases or decreases in the general price level were caused by changes in the supply of money and not by shortages or surpluses of oil, commodities or labor.

The chart below shows the supply of money (M2) as a percentage of GDP. The economy thrived with M2 below 50% throughout the Dotcom boom of the late 1990s but has since grown bloated with liquidity as the Fed tried to revive the economy from the massive supply shock of China’s admission to the World Trade Organization in 2002 — the introduction of hundreds of millions of workers earning roughly 1/30th of Western-level wages.

Money Supply (M2)/GDP

The massive supply shock helped to contain prices over the next two decades, perpetuating the myth of the Great Moderation — that the Fed had finally tamed inflation. Fed hubris led them to pursue easier monetary policy with little fear of  inflationary consequences.

All illusions eventually come to an end, however, and the 2020 pandemic caused the Fed to purchase trillions of Dollars of securities to support massive government stimulus payments. The MMT experiment failed disastrously, causing a $5 trillion spike in M2 without an accompanying rise in GDP. M2 spiked up from an already bloated 70% of GDP to more than 90%, before GDP recovered slightly to reduce it to the current 89%.

Trade tensions with China, coupled with supply chain disruptions from the 2020 pandemic and a sharp rise in natural gas prices — as industry switched from coal to reduce CO2 emissions — triggered price increases. These were aggravated by Russia’s invasion of Ukraine and resulting sanctions, leading to oil shortages.

Normally, high prices are the cure for high prices. Consumers cut back purchases in response to high prices and demand falls to the point that it matches available supply. Prices then stabilize.

But consumers are sitting on a mountain of cash, as illustrated in the above M2 chart. They continued spending despite higher prices and demand didn’t fall. Investors who have access to cheap debt also, quite rationally, borrow to buy appreciating real assets. Unfortunately cheap leverage is seldom channeled into productive investment and instead fuels expanding asset bubbles in homes and equities.

The Fed is forced to intervene, employing demand destruction, through rate hikes and QT deflate asset bubbles, to reduce consumer spending.

An unwelcome side-effect of demand destruction is that it also destroys jobs. Unemployment rises and eventually the Fed is forced to relent.

Conclusion

Fed Chairman Jerome Powell says that the Fed’s commitment to reining in inflation is “unconditional” but the bond market is pricing in rate hikes peaking between 3.0% and 3.5%, way below the current rate of inflation. The economy is unlikely to be able to withstand more because of precarious levels of debt to GDP and a massive fiscal deficit.

Instead, the Fed plans to shrink their balance sheet by $2.3 to $3 trillion. QT is expected to deflate asset bubbles in stocks and housing and achieve a reverse wealth effect. Households are likely to curb spending as their net worth falls and they feel poorer.

Unfortunately, demand destruction from rate hikes and QT will also cause unemployment, inevitably leading to a recession. The Fed seems to think that the economy is resilient because unemployment is low and job openings outnumber unemployed workers by almost 2 to 1.

Job Openings & Unemployment (U3)

But elevated debt levels and rapidly rising credit spreads could precipitate a sharp deleveraging, with crumbling asset prices, rising layoffs and credit defaults.

High Yield Spreads

The Fed may also manage to lower prices through demand destruction but inflation is likely to rear its head again when they start easing. Surging inflation is likely to repeat until the Fed addresses the underlying issue: an excessive supply of money.

Milton Friedman was a scholar of the Great Depression of the 1930s which he attributed to mistakes by the Fed:

“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 … Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”

Ben Bernanke, another scholar of the Great Depression, acknowledged this during his tenure as Fed Chairman:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton (Friedman) and Anna (Schwarz): Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”

Instead the Fed made the opposite mistake. By almost doubling the quantity of money (M2) relative to GDP (output) they have created an entirely different kind of monster.

Money Supply (M2)/GDP

Slaying the beast of inflation is likely to prove just as difficult as ending the deflationary spiral of the 1930s.