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  1. Home
  2. / Investing
  3. / Financial Services

The Fed Is Walking a Tight Rope

The biggest risk may not necessarily be what you think.
By GUEST CONTRIBUTOR
May 09, 2018 | 03:31 PM EDT

-- By Lance Roberts

In March 2012, Chris Cole of Artemis Capital wrote:

"Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation. The global fleet is tethered by chains of trade and investment so if one ship veers perilously off course it pulls the others with it."

At the time the letter was written, the most pressing concern for the global economy was clearly the "waterfall of deflation." Now consider the actions of the Federal Reserve since December 2015. The central bank has raised the fed funds rate five times and more recently began reducing its balance sheet, aka quantitative tightening (QT). In measured fashion, the Fed expects to continue both sets of actions, which will progressively reduce financial liquidity for the foreseeable future.

The removal of stimulus despite economic growth and inflation that is well within the range of the last five years raises important questions about the Fed's objectives.

Some will say that the Fed is concerned that inflationary pressures are building as witnessed by some corporate earnings comments and economic surveys. Others claim that the large fiscal deficits and tax reform are likely to provide a boost in the near future to economic growth and inflation and that its actions are pre-emptive.

While we acknowledge the possibility for an uptick in inflation, we think the main factor driving the Fed is the normalization of policy, both interest rates, and balance sheet, to provide itself the monetary ammunition for when it is needed next. Said differently, the central bank is looking beyond the current economy with an eye toward the next recession. As Chris Cole so graphically illustrated, however, the strait through which the global armada of ships now sail may appear less treacherous, but the reality is that accumulating global debt is actually guiding the fleet into even more treacherous waters.

Damned if They Do

If the Fed's overarching goal behind recent policy is normalization, it runs the risk of stamping out the recent uptick in economic growth and inflation. Given the $70 trillion of government, consumer, and corporate debt, interest rates are economically more important today than any time in the past. As such, each step higher in interest rates and reduction in balance sheet increases the sensitivities to debt and therefore reduces economic activity.

Damned if They Don't

The flip side of the argument is that if the Fed does not increase rates and reduce its balance sheet, it runs the risk that recent fiscal stimulus and dollar weakness will stoke inflation. While the Fed has a 2% inflation goal, letting inflation rise much beyond 2% would also impose upward pressure on interest rates and harm economic activity.

On her way out, Janet Yellen assured us the pace of Fed tightening would be "gradual and predictable." Mrs. Yellen seemed to understand the risks of moving too fast or too slow as summarized above but it was always couched in terms of the threat of derailing the recovery. What her analysis seems to have neglected was a long-forgotten scenario that has precedent in U.S. economic history.

The biggest risk may not necessarily be slowing growth or higher inflation but the combination of both, otherwise known as stagflation. Such an environment is a worst-case scenario for the Fed where debts are harder to service due to higher rates combined with weaker wages, tax base, and corporate earnings.

Stagflation would not only increase credit defaults but put significant pressure on stock prices and other risky assets that stand at elevated valuations based on low-interest rates. Perhaps most importantly, that scenario would greatly limit any ability of the Fed to intervene if the market swoons.

Real Money Guest Contributor Lance Roberts is Chief Investment Strategist of Clarity Financial, LLC and Editor-In-Chief of Real Investment Advice.com

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TAGS: Financial Services | Investing | Economic Data | Economy

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