We’ve all had those parenting fail moments, when our stern warnings turn to threats, and then our threats turn to more creative threats and then, nothing, as the kid gets away with it (for awhile anyway). My best frame of reference is in church when my son Sam was 3 or 4. Commands to stop squirming turned to subtle pressure on the arm turned to descriptive whispers of what was going to happen to him if he didn’t stop rolling under the pew, led to, coffee and donuts as Dad was now distracted and just glad it was over.
Well, we are pretty much at the end of our collective warning period when it comes to Federal Reserve policy. We investors and consumers were told the consequences for all the cheap and easy money passed out during the pandemic and the inflation it caused were soon coming, the consequences came, then they came some more. Despite the attempts to get us to calm down, markets and economic activity kept squirming and now we are clearly in the creative threat stage. This week, Fed Chair Powell, playing the role of annoyed parent, made this abundantly clear.
If there was any hope the current multi-decade-high level of interest rates was going to be temporary, after Wednesday this expectation must be considered delusion. Higher interest rates look highly likely to be here to stay for a while, and rates may even go higher before they go lower. While the personal implications of these higher rates depend on where one is in the economic cycle of life, the effect on the overall economy must be explored.
To make a wonky economic topic simple, the inflation continuing to pester the United States is due to a massive increase in the supply of money in the economy that can be used to fund transactions. While this increase in money supply originated over the past 14 years, the record extreme acceleration occurred during the pandemic years of 2020 to 2022. Said simply, to keep the economy going during lockdowns, the Fed created, and the government borrowed and spent, too much money over the past three years and now this is causing a stubborn inflation problem.
The most common measure of the supply of money in our economy is referred to as “M2”. To address inflation, M2 must come down, and this is what the Fed is trying to do with its current monetary (money supply) policy.
The methods in which M2 go down are complicated, but essentially money supply is continually reduced “organically” through a variety of consumer and investor behaviors. In a closed system, money supply would always tend to trend lower over time. But we don’t have a closed system. In a modern economic system, the general reduction in money supply is being continually offset by the corresponding growth of the money supply being also created by consumer and investor behavior. Or said simply, the way to shrink M2 is to grow it less quickly than the organic inherent reduction rate.
Every time any of us decide to open a credit card, use a loan to buy a car, take out a mortgage or pay tuition with a student loan we increase the money supply. This is because credit is the primary mechanism for money creation. Consumers tend to primarily increase their use of credit when they feel confident about the future, i.e., it just doesn’t make sense for someone who expects to lose their job soon to buy an expensive new car.
Consumers and investors are also highly impacted by interest rates in their credit use decisions. Low interest rates obviously encourage borrowing, higher rates discourage this behavior. With this understanding, the Fed has expressed its clear determination to use interest policy to change our collective behavior, and it is not going to be distracted by coffee and donuts. The Dad version of this is “we will be made less confident, and we will pay dearly for borrowing money.” This week they made it clear they intend to see this all the way through. I believe them.
So, is it working? Yes. M2 has been reduced at a rate never seen in the history of modern economics. According to the St Louis Fed, M2 has been reduced by 3.75% from June of 2022 to June 2023. While this may not sound like much, it’s a record pace of reduction. In addition, there have only been four previous times M2 shrank at a pace exceeding 2% year over year, and three of those four times resulted in financial panics or recession, and the Fed is not done.
How this will all end is still murky, and we may still escape the worst potential consequences. But the Fed put us clearly on notice this week. We may want to prepare accordingly.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. No investment strategy can guarantee a profit or preserve against loss. Past performance is not a guarantee of future results. This material may contain forward looking statements; there are no guarantees that these outcomes will come to pass.
