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Fed Balance Sheet Reduction Usually Results in Recession

By Gary D. Halbert. Originally published at ValueWalk.

  1. Strong July Jobs Report – Stocks At New Record High
  2. Fed Wants to Raise Rates, But Economy is Questionable
  3. Fed Balance Sheet Reduction Usually Results in Recession
  4. President Trump Will Dramatically Reshape the Fed
  5. What Fed Policy Changes Should We Expect Just Ahead?
  6. Webinar: YCG Investments – Wednesday, August 16, 3:00 ET

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Overview

The Fed remains committed to raising short-term interest rates at least one more time this year, most likely at the September policy meeting as I will discuss below. The Fed also wants to start reducing its massive $4.5 trillion balance sheet this year, but doing so in the past has almost always led to a recession.

The Fed knows this and thus finds itself in a very uncomfortable position. Do they raise rates and begin to reduce the balance sheet this year? Or is doing both too much of a risk? That’s what we’ll discuss today.

In addition, we’ll also revisit the fact that President Trump will have the opportunity to dramatically reshape the Fed’s 12-member policy committee during his time in the White House. Trump will get to replace six of the 12 members in the next couple of years. That could be huge.

Before we get to that discussion, I will comment on last Friday’s strong unemployment report for July. I will also share a few thoughts on the fact that the stock markets have once again soared to new all-time record highs. Let’s jump right in.

Strong July Jobs Report – Stocks At New Record High

The Labor Department reported last Friday that the economy added a higher than expected 209,000 new jobs in July. The pre-report consensus of economists suggested 183,000 new jobs in July, so the latest report was considerably stronger than expected.

Fed In A Real Quandary

The headline unemployment rate fell from 4.4% to 4.3%, the lowest level in 16 years. The number of employed Americans hit a new high of 153.5 million thanks to a surge of 345,000 in July. The employment-to-population ratio also moved up to 60.2%, tied for the highest level since February 2009.

The only disappointment in the latest jobs report was the fact that wages continued to rise at the paltry rate of 2.5% over the past year ended in July. Wages typically rise 3% to 4% a year when an economy recovers from recessions. But a slew of factors are holding wage growth down this time around.

Despite that, stocks soared to new all-time record highs again last week. The Dow Jones Industrial Average soared to above 22,000 for the first time in history. This historic rally in the Dow and other major indexes is thought to have been led by tech stocks, but this advance has been broad-based, as you can see in the chart below from CNBC.

Fed In A Real Quandary

The truth is, no one knows where this stock market is going. Corporate profits drive stock market valuations over the long-run, and profits are soaring. Market bulls will tell you that profits will soar even higher next year and the year after. That’s what they always say. But as we all know, the market tops out when it’s least expected.

The same will be true this time around. This is why I recommend that you keep at least some of your assets in strategies that can move out of the market (or hedge long positions) from time to time in an effort to minimize losses during market downturns. That’s what we specialize in at Halbert Wealth Management. To learn more, call us at 800-348-3601.

Now let’s get to our main topic today.

Fed Wants to Raise Rates, But Economy is Questionable

The Fed Open Market Committee (FOMC) which sets monetary policy met on July 25-26. As expected, the Committee made no monetary policy changes and left the Fed Funds rate unchanged at 1.0-1.25%. The policy statement which followed the late July meeting reflected the fact that inflation continues to run well below the Fed’s target rate of 2%.

This leaves the Fed in a very uncomfortable position. On the one hand, the Committee feels the need to raise the Fed Funds rate to more normal levels; but on the other hand, it does not want to choke-off the rather feeble economic recovery. It’s really that simple.

The debate is highly charged on both sides. Advocates for raising interest rates argue that the Fed needs to hike short-term rates ASAP to give itself room to lower rates again when we hit the next recession. Those who prefer keeping rates low argue that the economy is not yet strong enough to withstand higher interest rates, and doing so could spark a new recession.

Both arguments have merit. As such, the Fed has no good policy options right now. Despite that, the prevailing wisdom is that the Fed will raise rates at least one more time this year, either at the September 19-20 meeting or the December 12-13 gathering.

In the Fed’s policy statement released on July 26, the Committee added the words “relatively soon” which made many Fed-watchers conclude that another rate hike could well happen at the September FOMC meeting. Either that or the Fed might vote to begin reducing its $4.5 trillion balance sheet at the September meeting. But not both at the same time, most likely.

Most Fed-watchers are now referring to the upcoming reductions in the Fed’s balance sheet as “quantitative tightening” or QT. The Fed has hinted that its balance sheet reduction will begin in increments of apprx. $6 billion per month and slowly rise to $30 billion per month over the year following the first reduction.

There is one other wrinkle to keep in mind regarding a possible Fed Funds rate hike or balance sheet reduction in September. By the time the FOMC meets on September 19-20, we could well be into another debt ceiling standoff in Congress. That could complicate whatever policy decision the Fed might be considering. I’ll have more to say on the debt ceiling battle in an upcoming issue.

Fed Balance Sheet Reduction Usually Results in Recession

The Federal Reserve’s looming attempt to shrink its mammoth portfolio of bonds and mortgages comes with an ugly track record. Virtually every time the central bank has shrunk its balance sheet in the past, recessions have followed.

Over the past several months, the Fed has prepared the markets for the upcoming effort to reduce the $4.5 trillion it currently holds of mostly Treasuries and mortgage-backed securities. The balance sheet ballooned to this unprecedented level as the Fed sought to stimulate the economy out of its financial crisis morass by purchasing these securities.

Fed In A Real Quandary

The Fed has embarked on six such balance sheet reduction efforts in the past — in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000.

Of those six instances, five ended in recession, according to

The post Fed Balance Sheet Reduction Usually Results in Recession appeared first on ValueWalk.

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