Get 40% Off
🤯 This Tech Portfolio is up 29% YTD! Join Now to Get April’s Top PicksGet The Picks – Just 99 USD

Fiscal and Monetary Policy Shocks

Published 12/19/2022, 09:30 AM
Updated 07/09/2023, 06:31 AM

The cornerstones in my Inflation/Deflation and Economic Cycle Model are changes made to fiscal and monetary policies. Those are the two most determinant factors in any fiat-currency and debt-based monetary system.

Monetary policies have been ratcheting up tightly since March of this year when the Fed began to move away from its zero-interest rate policy. Quantitative tightening ramped up to $95 billion per month in September. Rate hikes will continue throughout the first quarter of next year, just as the extreme pace of balance sheet reduction continues to roll on.

The rapid increase in the Fed Funds Rate has depressed the demand for new loans. It has also led to the net percentage of banks tightening lending standards to soar from -32.4% in Q3 of 2021 to a positive 39.1% in Q4 of this year. In a debt-based monetary system, money is created when new loans are produced.

To this point, what is happening now is that the amount of fed credit (base money supply) is being destroyed at a record pace, just as banks are slamming the door shut on new loans due to the eroding economy. Hence, the M2 money supply has crashed from a humongous growth rate of 26.7% in February of 2021 to a year-over-year pace that is now shrinking.

The dysfunctional real estate market is the biggest reason for the drop in new loans and money creation. The S&P/Case-Shiller U.S. National Home Price Index was 123 in the middle of 2002. Home prices then soared to 184 at the peak of the Real estate bubble by the summer of 2006, which was an increase of 49.5% over the preceding four years.

This index now stands at a huge record high of 300! It was at 200 in March of 2018. That means from an already inflated level of 4 years ago, home prices have again shot up by 50%. And, most incredibly, home values are 63% higher than they were at the apex of the great real estate bubble. When you add in the steepest yield curve inversion in the past 40 years, you understand why banks are pulling in the reigns, shrinking the money supply, and abetting one of the greatest monetary tightening cycles in history.  

The fiscal screws have been tightening as the last vestiges of President Biden’s $1.9 trillion American Rescue plan, passed in March of 2021, get drawn down. But the fiscal pressure will begin to bite when the Expanded Child Tax Credit expires in 2023. The child tax credit was increased in 2021 from $2,000 per child to $3,600 per child under six and up to $3,000 for children ages 6 through 17. Therefore, for most consumers, there will be a tax hike of thousands of dollars per child beginning next year.

The recent FOMC meeting and press conference served to tighten the monetary screws by a further 50 bps. This move increased the Effective Fed Funds Rate to 4.3%, from zero percent only nine months ago. Listening to the press conference, one gets the impression that Powell wants you to believe he knows what he’s doing. Amazingly, the Fed's feckless nature and history of glaring incompetence have somehow emboldened Jerome Powell's overestimation of his ability to control the rate of inflation.

Let’s look at a bit of history. Powell's excuse for continuing with ultra-loose monetary policy, from when he assumed Fed Chair in February of 2018 to 2022, was that a central bank knows how to easily deal with inflation if that problem ever arises. Therefore, it was deflation that had become public enemy number one.

Any reading below 2% was intolerable. But, after inflation became intractable and the Fed's transitory inflation argument proved false, Mr. Powell's mantra completely flip-flopped. Over the past few months, he has repeatedly stated that inflation is now public enemy number one. That view was reiterated at Powell’s December meeting.

However, in complete contradiction to what he said years prior, the Fed Chair now claims that the Fed always has the tools to deal with deflation. During the last FOMC conference, he professed that if the current monetary policy regime overtightens financial conditions, the Fed can just return to QE and ZIRP to facilitate a reflation of the markets and the economy. Meaning Jerome Powell hasn’t learned a thing during his tenure at the Fed. He doesn’t care that ZIRP and QE engendered runaway asset bubbles and intractable inflation in the first place.

I highlight this glaring stupidity because it necessities allocating your portfolio according to these boom/bust cycles for your investment success because they will occur with more frequency and intensity over time. In other words, being long the correct asset classes, sectors, and style factors during deflationary and inflationary regimes is far better than buying and holding a 60/40 portfolio mix of stocks and bonds.

But for now, the Fed is enjoying a rare moment of sanity. Powell continues to fight inflation, and it is very slowly working. YoY CPI fell to 7.1% in November, down from the 9.1% rate in June. That is still too high for comfort, but at least it is moving in the right direction. Of course, Wall Street is celebrating the fall in inflation while completely overlooking the recession that runs concomitant.

The following are just a few of the recent data points that support the view that a recession is fast approaching:

  • The US personal savings rate is now just 2.3%. That is the lowest savings rate for consumers since records began in 1959.
  • The ISM survey for November showed the US manufacturing sector is shrinking for the first time in the past 29 months. And, while the ISM Service sector index rose to 56.5 in November, the US Services PMI for that same month signaled a faster contraction in business activity with a reading of just 46.2. The fall in output was the second steepest since May 2020, with a sharp decline in new orders.
  • The BLS' Establishment job survey showed 263k net new jobs were created in November. However, the Household Survey showed that 138k jobs were lost last month; and not one single job has been created in that survey since March of this year. Also, the average work week fell along with the aggregate hours worked.
  • Research firm Challenger Gray and Christmas announced that planned job cuts soared by 417% in November, with the highest number of layoffs in the tech sector on record.

Typically, at this point in the business cycle, the Fed would be reducing the cost of money. However, Powell is still making oversized rate hikes and doing QT simultaneously. He has no choice but to pursue tighter monetary policies. This is because the inflation rate is over 3x the Fed’s target level.

This fiscal and monetary tightening will cause nominal GDP to grow much slower and will lead the S&P 500 EPS to contract starting in Q4 of this year both sequentially and year over year. Despite all this, 71% of money managers in a recent Bloomberg survey predict an average gain of 10% in the S&P 500 next year. Meanwhile, the valuation of equities is the highest than at any other time in history, from the signing of the Buttonwood Agreement in 1792 to the start of 2020.

The monetary fuel from the government has been spent, and there is no fiscal rescue package coming from DC anytime soon. The consumer is sacked with a record $18.8 trillion in debt, and banks have cut back on lending due to the teetering housing market bubble. Nevertheless, Wall Street is overwhelmingly bullish on the market and the chances of a soft landing for the economy next year. The PPS IDEC Model differs immensely on that spurious conclusion.

Latest comments

Risk Disclosure: Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.
© 2007-2024 - Fusion Media Limited. All Rights Reserved.