#110 – Is the FED making the same mistake of 70s?

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#110 – Is the FED making the same mistake of 70s?

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Fed – In this article you’ll find:

  • Is the 7% the solution that will solve the inflation problem?
  • Why these days are different than the 70s
  • How could behave risky assets in 2023
  • How inflation and Fed rate policy is set for 2023

Here you can find other articles:

  1. What are the consequences for investors with a recession?
  2. Unemployment low (for now) and no good news in horizon about it
  3. The deeper the recession, the deeper the earnings decline will be. Even in China?

ENJOY THE ARTICLE

Introduction

Through the end of Q3-2022, using quarterly data, the stock market has returned almost 184% from the 2007 peak.

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The critical takeaway is that while the Fed’s policy of low-interest rates pushed capital into the financial markets.

It did so at the expense of economic growth.

The debt accumulation needed to sustain a “living standard” has left the masses dependent on low rates to support economic activity.

Most likely, the Fed’s “7% solution” will solve the inflation problem caused by the massive stimulus injections following the pandemic.

Unfortunately, the medicine will most likely kill the patient in the process.

The enormous debt load is the most crucial difference between applying the “7% solution” today and in the 70s.

Today, consumers, businesses, and even the Government depend on low-interest debt to sustain an ongoing spending spree.

A “7% solution” could pop the massive “debt bubble,” leading to severe economic consequences.

Just recently, James Bullard, President of the St. Louis Federal Reserve, suggested the central bank might need to employ the “7% solution”.

To ensure the complete destruction of inflation.

As real investment advice has discussed previously, the fear is repeating the policy errors of the late 1970s that led to entrenched inflation.

Trying to increase the Fed funds rate to 7%, 2.5% higher than they are currently, risks triggering a catastrophically deep recession.

The reason is the 2020 inflation was the result of one-time artificial influences versus the 1970s.

FED – This time is different

The Government ran no deficit, and household debt to net worth was about 60%.

So, while inflation was increasing and interest rates rose in tandem, the average household could sustain their living standard.

The chart shows the difference between household debt versus incomes in the pre-and post-financialization eras.”

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What happened in the 70s?

What was most notable is the Fed’s inflation fight didn’t start in 1980.

Persisted through the entirety of the 60s and 70s.

Repeatedly, the Fed took action to slow inflationary pressures, which resulted in the repeated market and economic downturns.

Stocks Set to Fall Near-Term as Economic Growth Slows

Source: Jp Morgan Global Research

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The global economy is projected to expand at a sluggish pace of around 1.6% in 2023.

Financial conditions tighten, the winter aggravates China’s COVID policy and Europe’s natural gas problems persist.

The global economy is not at imminent risk of sliding into recession.

The sharp decline in inflation helps promote growth, but the J.P. Morgan Research baseline view assumes a U.S. recession is likely before the end of 2023.

In the first half of 2023, the S&P 500 is expected to re-test the lows of 2022, but a pivot from the Fed could drive an asset recovery later in the year, pushing the S&P 500 to 4,200 by year-end.

What we hope to achieve is a period of growth below trend

Jerome Powell recently said

That last sentence is the most important.

After the ‘Financial Crisis,’ the media buzzword became the ‘New Normal’ for what the post-crisis economy would like.

It was a period of slower economic growth, weaker wages, and a decade of monetary interventions.

To keep the economy from slipping back into a recession.

Post the ‘Covid Crisis,’ we will begin to discuss the ‘New New Normal’ of continued stagnant wage growth, a weaker economy, and an ever-widening wealth gap.

Social unrest is a direct byproduct of this “New New Normal,” as injustices between the rich and poor become increasingly evident.

If real investment advice is correct in assuming that PCE will revert to the mean as stimulus fades from the economy, then the ‘New New Normal’ of economic growth will be a new lower trend that fails to create widespread prosperity.

Risky asset classes in 2023

There is good and bad news for equity markets and more broadly risky asset classes in 2023.

The good news is that central banks will likely be forced to pivot and signal cutting interest rates sometime next year, which should result in a sustained recovery of asset prices and subsequently the economy by the end of 2023.

The bad news is that for that pivot to happen, we will need to see a combination of more economic weakness, an increase in unemployment, market volatility, decline in levels of risky assets and a fall in inflation.

All of these are likely to cause or coincide with downside risk in the near term.

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The problem comes if inflation remains elevated and interest rates adjust to higher levels. Such would trigger a debt crisis as servicing requirements increase and defaults rise.

Historically, such events led to a recession at best and a financial crisis at worst.

The Forecast for Rates and Currencies

Over the past year, the Fed has been forced to tighten aggressively, outpacing every tightening cycle over the last three decades.

For 2023, it is no surprise that inflation and Fed rate policy remain top of mind for investors: in the J.P. Morgan Research 2023 Outlook Survey, respondents ranked these two factors as the most important for U.S. fixed income markets in 2023, followed by U.S. recession risks.

“The almost 500bp of expected cumulative hikes is already delivering a commensurate tightening of financial conditions, which we believe will tip the economy into a mild recession later next year.

With a slowing in aggregate demand, we project the unemployment rate will rise to 4.3% by the end of next year,” said Jay Barry, Co-Head of U.S. Rates Strategy at J.P. Morgan.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics.

In doing so he shares with you the most interesting charts and comments.

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