The mandate of the Federal Reserve is to be a lender of last resort during a liquidity crisis and to maintain maximum employment consistent with a stable currency (low inflation). The Fed does NOT have a mandate to support the asset markets (stocks, bonds, real estate) although they have done this for the past 10+ years.
The Fed has a difficult job because consumer price inflation results from extra cash in consumer hands – which was provided by Congress to the tune of about 10% of GDP in 2020-2021. Fed actions control the cost of money to the banks (monetary stimulus), not to consumers (fiscal stimulus). The Fed’s actions impact asset prices much more than consumer prices. Monetary impacts on consumer prices are indirect and slow.
**The Fed Missed Inflation. Can Jay Powell Tame It Without Causing a Recession?**
**Chairman engineered an economic rescue but now has tricky task of cooling prices without hampering growth**
**by Nick Timiraos, The Wall Street Journal, 2/15/2022**
**At their meeting next month, Fed officials will release new projections showing how much they expect to lift rates. Thus far, their goal has been to raise them to “neutral,” a level that neither spurs nor slows growth, which officials estimate is between 2% and 3% when inflation is near the Fed’s 2% target. [** [“Rates” means the overnight and fed funds rates, which are short-term rates. The Fed wants to stop controlling long-term rates by ending their buying Treasury and mortgage bonds. – W]
**Complicating its deliberations, the Fed has more than one way of tightening policy by shrinking its bondholdings [long term], which have more than doubled to $9 trillion since March 2020....**
**Looming over this is the reaction of the markets. Stocks, corporate bonds and real estate all reached historically high valuations in part on the assumption rates would remain very low for years. Though household borrowing as a share of U.S. gross domestic product is well below levels reached during the housing boom of 2004-06, corporate debt is near a record high....** [end quote]
This is a long article with a lot of information. These few paragraphs hold the meat for us as investors.
The Fed has not held its Fed funds rate at 2% - 3% since 2019. Currently, it’s 0.08%. Raising it to the “neutral” rate of 2%-3% would flatten the yield curve unless long-term yields also rose – which they will if the Fed sells even a fraction of its huge book of bonds.
“Neutral rates” sounds very benign. In fact, it should be very benign. The Fed is supposed to support the economy, not control it.
The problem is that rates at all maturities are so far below “neutral” or their historic norm that any attempt to return to neutral will devastate both bond owners and companies that have to borrow. Especially companies that can’t pay their debts from cash flow and must borrow to roll over existing debt. That’s a path to bankruptcy.
Bond yields are already rising. I think that there will be more to come. This is not a good time to be holding long-term bonds.
It’s also not a good time to be holding the shares of companies that have a lot of debt, especially short-term debt that will need to be rolled over soon. Especially companies that aren’t profitable. More than 600 U.S. companies are zombies, defined as not making enough money to pay the interest on the debt they’ve accumulated. The Fed says that roughly 10 percent of public firms and five percent of private firms are zombies. Listed firms classified as zombies are highly concentrated in the manufacturing sector.
The bland term “neutral” can lead to some very un-neutral results in the asset markets.
The pressure on the Federal Reserve to control consumer price inflation – which is largely caused by factors out of its control – could cause actions that smack down asset price inflation. That is, the value of our stocks and bonds.