Will the Federal Reserve’s Latest Decision Lead to Recession?


At last week’s Federal Open Market Committee (FOMC) meeting, the Federal Reserve made two major policy decisions. First, the FOMC raised the target federal funds rate 50 basis points, to ¾ to 1 percent. Second, the Fed finally committed to making cuts to its balance sheet in order to return the balance sheet to more normal levels.

Starting June 1st, the Fed will be cutting its balance sheet by up to $47.5 billion per month, starting with a drawdown of $30 billion in Treasury securities and $17.5 billion in mortgage-backed securities (MBS) per month. After three months, those caps will rise to $60 billion and $35 billion per month respectively.

Both of those measures taken together are supposed to help combat inflation that continues to rise. But is it too little, too late? And could the Fed’s actions end up causing a severe recession instead?

Open-Ended Timeline

In true Fed fashion, Chairman Jay Powell was light on details in last week’s FOMC press conference. He won’t commit to any course of action for any fixed period of time, nor will he announce ahead of time what might get the Fed to change course.

What we’re looking at is a balance sheet reduction that would take about $1.1 trillion off the Fed’s balance sheet each year. Right now the Fed’s balance sheet is at about $9 trillion, and many analysts expect the Fed to target a balance sheet size of around $6-7 trillion. But is that feasible?

The last time the Fed tried to draw down the size of its balance sheet, markets revolted. That drawdown lasted only a few short months before the Fed reversed course. And now we’re supposed to believe that the Fed is going to move to an accelerated drawdown that pulls more money out of the financial system and stick to it?

Even before the last drawdown attempt, markets revolted during the “Taper Tantrum” of 2013. Financial markets have become so addicted to easy money that when the Fed reverses course and tries to return to some sense of normalcy, it risks crashing markets.

Markets today are like an alcoholic waking up the morning after a massive bender, or a junkie who just got his last fix and has nothing more to turn to. The effects of the Fed’s decision could very well help precipitate just the kind of meltdown it was trying to avoid, bringing on a recession that could be worse than it otherwise would have been, and potentially even worse than 2008.

The Effects of the Fed’s Policies

The Fed’s monetary policy has always moved markets, but even more so today given the vast amounts of liquidity the Fed has pumped into the financial system. The two major aspects of Fed policy to look at today are:

  1. Interest Rate Hikes
  2. MBS Sales

And the main impacts from the Fed’s monetary policy about-face could fall on:

  1. Stock Markets
  2. Housing Market
  3. Investors

Interest Rate Hikes

The Fed’s 50 basis point interest rate hike was the largest since 2000. And markets are pricing in further 50 basis point hikes over the course of the year, with expectations that the target federal funds rate will likely be between 2.5% and 3.5% by the end of the year.

With inflation currently at 8.5%, that’s not a very high target rate. The last time the Fed got serious about curbing inflation, during the Volcker era in the early 1980s, the Fed pushed the effective federal funds rate to over 19%, at a time when inflation was peaking at just under 15%.

So by historical standards the Fed, even if it were to raise rates aggressively over the course of the year, is still going to be lagging inflation. If it were really serious about curbing inflation, the federal funds rate should be more like 10% or 11% today. But that of course would completely devastate debt markets, and with a record debt bubble facing the economy today, it would be catastrophic.

Long story short, don’t expect what the Fed is doing to curb inflation in any meaningful way. But do anticipate negative impacts on markets.

MBS Sales and the Housing Market

The Fed’s sales of mortgage-backed securities could have a far more significant impact on markets than anything else it is doing. Yet you hardly hear anything about this in the mainstream financial media.

For years the Fed’s purchases of MBS have buoyed the housing market, providing liquidity and keeping interest rates low. In fact, the Fed owns about 23% of all outstanding mortgage-backed securities. This massive subsidy to the housing market, however, is about to come undone.

Just look at what happened when the Fed decided to stop asset purchases. Mortgage rates shot up from under 3% to over 5%. Now the Fed is going to sell MBS into the market, adding supply to a market that could already be over-saturated. What will that do?

It’s highly likely that these MBS sales will help mortgage rates spike even higher, which could harm first-time homebuyers. And if demand for houses drops, don’t be surprised to see housing prices fall significantly.

Stock Markets and Investors

Wall Street has already seen its first case of the jitters as nervous investors head for the exits, afraid of what lies ahead after the Fed has decided to go ahead with its monetary tightening. Markets ended last week with a horrendous Friday, and haven’t gotten off to a great start this week either.

So far this year the Dow Jones Industrial Average is down nearly 12%, the S&P 500 is down nearly 17%, and the Wilshire 5000 is down over 18%. Those are not numbers that investors want to see. And the worst part is, this may only be the beginning.

After over a decade of loose money, a Federal Reserve that is actually tightening monetary policy means that institutional investors, hedge funds, and other professional money managers no longer have the luxury of a Fed backstop. They won’t be playing with house money, won’t be able to rely on Fed support, and will actually have to consider the possibility of real losses.

Over the decades, stock market performance and monetary policy have gone hand in hand. Since the Fed began quantitative easing in 2008, there is a 96.8% correlation between the M2 money supply and the performance of the Dow Jones Industrial Average. So the Fed tightening money, and potentially shrinking the money supply, will very likely result in stock markets suffering real losses.

Gold and Recession

The jitters that many are feeling today are one of the reasons so many people are looking to protect their assets ahead of a crash. And more and more people are looking to protect their assets with gold.

Many people watched in horror in 2008 as their investments lost money. And then lost more. And then lost even more.

By the time things were all said and done, stock markets had lost over 50% of their value from their highs in 2007 to their low in March 2009. But during that same time period gold gained over 25%, and never looked back.

While millions of people looked at their 401(k) and retirement accounts and wondered when they were going to regain the value they lost, gold kept on going, hitting record highs by 2011. Many people looked at gold’s performance back then and vowed that the next time a crisis threatened, they would protect their assets with gold. Is now that time?

With modern investment vehicles like a gold IRA, protecting your hard-earned wealth with gold can be easier than ever. A gold IRA is just like any other IRA account and offers the same tax advantages, but it allows you to own physical gold coins or bars. And you can fund your gold IRA by rolling over or transferring assets from your existing 401(k), IRA, TSP, or similar accounts into a gold IRA tax-free.

If the Fed’s latest monetary policy decisions have you nervous about the safety and security of your savings, maybe it’s time you started thinking about protecting yourself with gold. Call the precious metals experts at Goldco today to learn more about defending your financial well-being with gold.

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About the Author: Paul-Martin Foss