I’ve been thinking about a couple of “rules” that I have ignored to my peril over the years.
- Don’t fight the fed.
- Follow the common knowledge, which is that which everyone knows that everyone knows (see Epsilon Theory site).
I am perhaps compulsively contrarian in my crotchety old age. Consider 2021 when the fed started to tighten, and everyone knew that everyone knew higher interest rates reduced the value of future earnings and that high growth and no profit tech stocks in particular would suffer price declines. But high growth would power through all that. Growth! Well, that didn’t work out well for me. The algorithms knew and they didn’t fight the fed.
So I am mindful of these rules. But to the contrary, as I continue to read about the fed and watch its machinations, I just can’t help the feeling that it is a group of grade school kids in clown costumes pretending to be doing grown up things. Like, making calibrated moves of the overnight cost of funds, a lever that is not connected to anything resembling a control device. “Long and variable lead time” as in we don’t know what will happen, or when, or whether it was us or a butterfly in Botswana. In any case, I do know that there is something called Instrumentation and Feedback Control. I know that because I flunked that class and had to change minors from Nuclear Engineering option to any damned option that I could find in order graduate and move on to pilot training where I learned about feedback control and pilot induced oscillations, though not on either an academic or personal level. But the point for the Fed is that if one is to control something, one must know the system response time and the control response time and the current conditions. But the Fed steers the economy (or so pretends) by looking in the rearview mirror and “steering” with a lever which has only secondary or tertiary influence on the thing they are trying to achieve.
I bring this up specifically with regard to the great effort, watched so intently by “The Market”, to bring sticky inflation under control. If I were an economist, or played one a web site, I would be Austrian to the core. Show me the M2 and I will show you the inflation outlook. My critique is that the Fed is too late with the rate cuts and should have continued the quantitative tightening (reduction in balance sheet and M2) for just a few more months. The higher than normal, restrictive, interest rate will eventually reduce economic growth to below neutral. The cuts they projected at the end of 2023 might have produced a soft landing as long as the real control variable, M2, had been reduced just a little more.
The long term growth in M2 from 1960 through 2019 was 6.75% CAGR. At the end of 2019, the M2 was 15.381 T dollars. By May 2022 the M2 was 21.691 T versus what would have been just 16.871 at normal CAGR, an increase of 28.6% above trend. What was the inflation in those 2-1/2 years? Then the Fed started tightening and by end of February were at 20.774 T. If they had held there, then here in August the M2 trend line would be at 20.746 T. The glide path was there, inflation was coming down, job growth was softening (at best) and the Austrian in me was saying ease on the rates. Seems Fed is being flown by a carrier pilot or Divine Wind type. Don’t need to fly it into the deck, just ONTO the deck. So, I think this is a problem with “data dependence” and a gross overestimation of response effectiveness and response time–as in sticky, long, and variable.
Which for me provides some comfort in holding short term treasuries, a little bit of dividend stocks, and some moon shots.
In other words, I’m fighting the Fed (?) and…, I’m not sure which is what everyone knows that everyone knows. I think that category is that the recession happens after the Fed cuts and the market goes down also. We shall see.
KC
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