The Federal Reserve is trying to stamp out inflation without pushing the economy into recession, but the effort is akin to drawing blood from a stone. While everyone agrees that this task is extremely difficult, a think tank from Societe Generale proposed a bipolar policy in which a soft landing could be achieved if rate hikes slowed.
The Fed has two choices in the fight against inflation
The research team at one of France’s oldest banks argues for a two-pronged approach, led by Societe Generale Quant Research director Solomon Tadesse. The Fed will either have to opt for a growth-centric or inflation-centric approach:
- Stifled inflation would pull the rug out from under the stock market, as it is used to the cheap cost of capital. This would result in a total interest rate hike of 9.25% and a balance sheet reduction of $3.9 trillion as QT.
- Alternatively, a growth-oriented policy would result in a half-measure, like a soft landing.
In other words, the Fed operates within this cost-benefit spectrum. The Fed must choose the gravity of the landing so that few wheels fall. One of these wheels is the employment rate if monetary policy leads to a recession.
The Fed’s Hot Potato Juggling
The very reason the Fed more than doubled its balance sheet was to avoid the stock market crash during the C19 event. In turn, the central bank imposed a tax in the form of inflation. That was the long-term cost of that decision.
Although inflation cannot be called a tax, it acts as such, imposing a general increase in the cost of living. Now that this “tax” is becoming politically problematic, a reversal of the balance sheet is necessary. Specifically, the reduction of Treasury securities as public debt.
By buying up Treasury securities, as well as mortgage-backed securities (MBS), at a monthly cap of $60 billion, the Fed can gradually reduce its bloated balance sheet. This quantitative tightening (QT) will slowly intensify by the end of 2022.
In turn, just as quantitative easing (QE) drove interest rates down due to Fed money flooding the banks, quantitative tightening (QT) drove interest rates higher. After all, the banking system is then emptied of excess money, thus undoing QE.
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Inflation-hedge assets decline as macro conditions remain uncertain
To illustrate further, the monetary spectrum between QE and QT is equal to heating or cooling the economy. Inflation is a clear manifestation that the economy is overheating, inflating the stock market over the past two years as the Fed got it hooked on cheap borrowing.
The soft landing then cools the economy without pulling the grass underfoot too harshly. Last Thursday, Fed Chairman Jerome Powell admitted that it would be quite difficult.
“So a soft landing is really getting back to 2% inflation while maintaining a strong labor market…Whether we can execute a soft landing or not may actually depend on factors that we let’s not control.”
Jerome Powell in a interview in the marketplace
During her European tour, US Treasury Secretary Janet Yellen clarified on Wednesday that some of these uncontrollable factors are global food and energy price hikes following the conflict between Ukraine and the Russia. These can trigger the worst-case scenario: stagflation—a cooling economy with high unemployment and inflation.
For now, assets considered growth-oriented are the hardest hit. Specifically, the tech-heavy Nasdaq index and bitcoin.
Interestingly, the so-called inflation hedges – gold, silver, bitcoin – perform the best, in hopes that the Fed will manage to keep inflation under control.
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About the Author
Tim Fries is the co-founder of The Tokenist. He has a B.Sc. in Mechanical Engineering from the University of Michigan and an MBA from the University of Chicago Booth School of Business. Tim was a senior partner on the investment team in the US Private Equity division of RW Baird and is also a co-founder of Protective Technologies Capital, an investment firm specializing in detection, protection and control solutions.