Same old Fed?

The Fed, under its new Chairman Kevin Warsh, said last Thursday that it will be purchasing $10 billion per month of Treasuries to ensure the banking system has ample reserves. He reasserted the proclivity for balance sheet growth at his first FOMC meeting and press conference. I have two problems with this. One, Mr. Warsh was purportedly going to shrink the Fed’s balance sheet and bring on a regime of scarce reserves. This would greatly reduce the central bank’s footprint in our economy, but it’s not looking good so far. Two, the Fed increased its balance sheet by $14 billion last week alone, which is way above the entire monthly target. I had hoped that Kevin Warsh would be different from his predecessors because he claims to be an Austrian economist. But he has certainly stumbled right out of the gate. As for what he was going to do about inflation being above target for over five years, he said, “There’s a task force for that.” He doesn’t need a task force to understand that he needs to stop its rapid growth. It is the most effective way for the Fed to bring price stability back to Main Street.

But the sad truth is that he, like the other chairpersons before him, knows that the next recession could and should quickly devolve into an elongated depression because of the massive overvaluation of asset prices. Hence, they will do anything and everything, including printing trillions of preemptive dollars’ worth of credit, to delay that outcome for as long as the markets will allow. After all, nobody wants to be blamed for steering the economy into a deep depression.

I’m not sure if the Fed is composed of individuals who are nefarious, inane, or insane. Perhaps it is a combination of all three. But what I am convinced of is that they are frightened to death of the next asset price implosion. For what the members of the FOMC are aware of but will not speak of is that they will be impotent to ameliorate the next collapse. This is true because whenever the economy suffered from a contraction in growth and asset prices in the past, the government was able to assist by using its balance sheet. Even though past collapses lasted years and took asset prices down by 50%+, the Treasury borrowed immensely and the Fed monetized the debt. Hence, asset prices eventually turned higher and the economy began to heal. For example, during the GFC, the Treasury borrowed about $1.4 trillion, and the Fed bought $1.3 trillion of that debt. But back then, the nation’s debt-to-GDP ratio was just 63%. So, there was room to spend and print the problem away without damaging the dollar or our sovereign debt market. In other words, by printing new money and buying government debt, the Fed was able to push interest rates lower by removing the debt from being priced by the market.

However, that free pass has been removed. During the post-COVID era, our nation’s debt has surged by $25 trillion and now sits at 123% of GDP. And the Fed has already massively expanded its balance sheet when it monetized $5 trillion of that debt at its peak. This process has produced a humongous spike in the level of prices and has sent the CPI rising well above target for over five years. This means that, heading into the next recession, we will already be suffering from an intractable inflation problem combined with a nation struggling with solvency (think about $2 trillion deficits and a debt-to-revenue ratio of 720%).

Whenever the next recession arrives, the deficit should surge by trillions of dollars as the automatic economic stabilizers of unemployment insurance, SNAP, and reduced taxes are triggered. The debt problem will be exacerbated if the Treasury tries to assist with another American Recovery and Reinvestment Act, which was a massive $831 billion economic stimulus package signed by President Barack Obama in response to the Great Recession. Or it will be even worse if the government once again sends trillions of dollars in stimulus checks, UBI, and helicopter money drops.

Therefore, interest rates will most likely rise during the next economic crisis no matter what the Fed does. If it chooses not to monetize the debt, it must then get priced by the free market at much greater yields. Conversely, if the Fed is forced to create trillions of dollars in new credit and buys it all, as it has done in the past, it should crater the dollar, destroy whatever credibility remains in our Treasury debt, and send inflation rates much higher than their current onerous level. Of course, yields will rise in tandem, thus not only delaying any economic recovery but also protracting and intensifying the decline.

Because of these dynamics, investors will be subject to intractable inflation, deflation, and stagflation at different times. Active management is the best approach to make sure you own the best stocks, bonds, currencies, commodities at the correct time.