I often think of an offhanded comment from the Chicago Fed Chairman Charlie Evans at a networking event shortly after the financial crisis. He said policymakers didn’t know what would happen after their extraordinary measures following the financial crisis. His point that much of what they did had never been tried before was true. I was shocked, however, by the implication that they were guessing with trillions of dollars. They decided it worked great, which brings us to their current situation.
Once again, the pandemic introduced something they had never seen before. The previous money printing and rate-setting experiment turned out well the last time, so they decided to repeat it. After all, inflation remained in check after 2008, employment grew, and the housing market recovered. Once we hit 2018, they finally decided we were in a place where rates could increase. In December of that year, the market decided it had enough increases and fell on its face. December 2021 volatility indicated that this could happen again but steadied as the month went on. This brings us to 2022.
They say that the first month of the year often sets the course for the remainder of the year for equity returns. Opening with a 7% + drop (as of this writing) in the S&P following a year with only one losing period of 5% is not a great sign. This time the experiment is turning out differently as inflation hit near a 40 year high to end the year at 7%. So what is the Fed to do?
Chairman Powell decides that inflation is the biggest concern, so he raises rates. This increases borrowing costs for all markets at the same time the Federal Reserve sells off fixed-income holdings they have accumulated since the beginning of the pandemic. All publicly-traded companies hold significant amounts of debt to generate leverage that reduces the weighted average cost of capital. This optimal capital structure is based on the research of Modigliani-Miller. A simplified view of this is that companies can maximize shareholder value by issuing debt instead of raising money through share offerings. Reducing taxes owed because of the interest paid (which can be written off) can help achieve higher shareholder returns. A shift in the bond market can increase the weighted cost of capital and reduce the value of all companies. We may be seeing some of this “unwinding” now.
The Federal Reserve decides that full employment and avoiding recession is the primary goal (if they believed we were near recession). In this case, they would not raise rates or do so very slowly while holding their bond holdings until maturity. This might keep asset prices elevated, but the cost of the delay could be higher material costs, energy costs, wage growth, and more. We covered this topic in May 2020 with our “Inflation Coming?” Article. Spoiler alert, as covered above, it is here and may be growing.
They strike the perfect balance and raise rates at a pace that satisfies both criteria. This assumes that no events occur that could impact that timing.
To put it bluntly, the Fed is in a pickle. Many of the effects they thought they could avoid are occurring already. Workers aren’t likely to accept pay cuts, higher input prices reverberate through the supply chain, and companies need to take higher interest rates into account for every new project they might consider. Whatever they do will have consequences. I hope they know what they are doing.
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