How Fed Tightening Will Lead To Recession
by David Reavill
Yesterday was the beginning of QT, that’s Quantitative Tightening in Fed speak.
It is the effort of the Central Bank, to curb inflation. Which is currently running at better than 8% in this country, a 40-year high.
What few people realize is that this entire financial strategy is less than 15 years old. And while it has been implemented since the 2007–08 financial crisis to stimulate the economy.
It has never, I repeat never, been used to slow an economy’s inflation.
In short, we are in uncharted waters.
Perhaps a little background is in order. And as this is a reasonably complex subject, we’ll keep this discussion just on the top line.
Historically the primary monetary tool of the Federal Reserve was interest rates. Oh, sure there were other tools at their disposal like adjusting the Bank Reserve Requirement or changing margin borrowing requirements.
But the number one method was to raise or lower interest rates depending upon how the economy was fairing.
Raise rates when things got too hot, and inflation was a problem. Like right now.
Or lower rates when the economy was struggling and about to go into a recession.
Now before we declare that this doesn’t sound like a very powerful monetary tool. I remind you that Paul Volcker back in 1980 used just this strategy to break the back of inflation that was at least as virulent as today’s inflation.
But when the Great Financial Crisis, so-called, began in 2007, then-Fed Chairman Ben Bernanke decided that simply lowering interest rates would not be enough to get the country out of that recession.
So borrowing a page from the Japanese, who were the ones to really begin Quantitative Easing in the modern era. Bernanke brought Quantitative Easing to this country.
And again there are several wrinkles to this strategy, but at its heart, it is a simple buying and or selling of bonds. Thereby either putting money into the system or taking it out.
Now the best way to understand this is to follow the money. Let’s assume that the Fed wants to provide money. Then it buys bonds, almost always US Treasuries, sometimes mortgage-backed bonds.
So, if you are a Fed Dealer, and the Fed steps up and buys your bonds. At the end of the day, the fed has your old bonds, and you now have excess cash to lend out to your customers.
The financial system becomes flush with cash. Cash which hopefully promotes economic growth.
And that’s exactly where we’ve been. The Fed has bought and bought and bought bonds. For 14 years.
Want to know how many bonds the Fed has purchased? Oh, just a cool $4 trillion dollars worth. Bringing the total holdings of bonds, and various agencies to nearly $9 trillion dollars worth.
Clearly, the Fed understands how to purchase bonds.
But now, from the Fed’s point of view, the economy doesn’t need any more help. In fact, they’ve probably gone too far, and now they need to cool down the economy and cool down inflation.
As a side note. This is how the Fed sees the world. But there are some of us who do not see this economy as that strong. And in fact, it’s my position that now that the Fed has started tightening, we’re going to find ourselves in a recession PDQ.
But back to the Fed.
So yesterday the opposite strategy began. Whereas before the Federal Reserve was a buyer of bonds. From now, until the foreseeable future, the Fed will be a seller of bonds. And remember, altogether the fed has $9 trillion to sell.
When we follow the money. The fed sells the bonds to dealer banks. At the end of the day the banks have bonds, but the fed has cash. Cash that has come out of the banking system. Cash that no longer can be lent to customers.
Finances become tight. Loan requirements are tightened by the banks. Because they can no longer make as many loans as they used to.
So now the Fed is using both major strategies they have to tighten.
They are raising interest rates, and they are directly removing funds from the financial system.
They’ve got their foot on the brake pedal, while they pull on the parking brake.
Obviously slowing is their objective. And I believe they are going to be wildly successful.
At slowing that is.
In fact, shortly we should all find ourselves flung out of our seats and hitting the windshield.
So get out your journal and write it down. We’ve begun a brand new season.
The season of Quantitative Tightening.
A time when the Fed uses not one but two ways to slow this economy.
Today’s Economic News:
I’m sure it was only a coincidence.
But you have to admit it was a bit odd.
So President Biden announces he is sending a new set of missiles to Ukraine.
These are those Long range missiles.
Missiles that can presumably hit Russian soil.
Then the Russians immediately started nuclear war drills.
And the markets crashed. Went from solidly positive to a 400 point drop in the Dow
Odd wasn’t it?
I’m sure it was only a coincidence.
In what should be the biggest story of the day. Shanghai is reopening.
After weeks of lock-down, under the Chinese Authorities Zero Covid Policy, those same authorities have now decided to re-open what is the world’s largest shipping port complex.
This had the residents of Shanghai dancing in the streets last night.
And should do much the same for the World’s supply chain.
In economic news today first reporting will be the ADP report on the number added to the employment rolls. Wall Street is looking for a nice bump here.
However then comes an important, but often overlooked report on Productivity.
We normally look for a slight increase in Productivity as new technology and experience keep building on the world’s most productive workers.
However, economists are looking for a major drop here.
We have to watch today’s report carefully, as this would indicate a serious weakening in the economy.
Finally, the latest numbers on gasoline storage will be reported. And I’m looking for another draw-down in gasoline stocks.
In earnings today, a couple of tech stocks report from the West Coast: Broadcom and Crowdstrike Holdings both reporting later this afternoon. Also reporting today are Luluemon Athletica and Hormel Foods also later today.