You Already Know the Next Move in Monetary Policy

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At the end of July 2019, the Federal Reserve will decide once again what to do about interest rates.

What’s going on in monetary policy?

The FED has clearly become more accommodative in conducting monetary policy. While this gives some oxygen to the markets in the short-term, it creates many risks for investors over the longer term because, like it or not, they are seriously manipulating the economy and this may eventually lead to a bad end.

Right now, there is a rising sentiment towards a rate cut, this is also confirmed by the FED’s declarations from the last meeting. If this will happen, it might give another short-term push to the economy but at the end of the day it means lower room to maneuver when the next recession comes.

This kind of behavior creates both a risk and an opportunity for the the long-term investor because, given how things are playing out, they may eventually lose control on monetary policy.

Let’s analyze all those facts in details.

From Hawkish to Dovish

Monetary policy’s job is to balance the economy, making sure that jobs and wages growth is increasing as much as possible without “overheating” and translating into an unsustainable rise in the inflation rate.

The Federal Reserve always stated that they are paying close attention to economic data in making their decisions on monetary policy. That’s fine, but what should get your attention is the general change in their strategy:

  • Until March 2019 there were rising rates expectations, everyone talked about tapering and get back from QE
  • After March 2019, the decision was to keep interest rates unchanged without any real expectation for further hikes in 2019
  • After June 2019 meeting, they kept rates unchanged but the sentiment for the near future shifted significantly towards rate cuts and more expansion

It is clear that in the last few years monetary policy became one of the main drivers of economic growth.

Understanding that is a key to correctly frame our economic environment and make investing decisions.

The following chart shows the level of interest starting from the 1960’s, definitely more interesting than the 0.25% increase or cut in short-term interest rates.

Soure — FRED

What this chart shows it that the world has seen declining interest rates since 80’s. In the recent years, just the small hike from zero to 2.5 has already produced effects on the economy, in fact the FED is already thinking that the new neutral rate could be lower than they thought (2.5–3%).

In the years, Government, Businesses and Consumers got more and more debt because it was cheap and now we find ourselves highly leveraged in every area. There is an extremely indebted environment that is a critical element of fragility in the whole system. Things didn’t really improved since 2008, we could argue that they are worse indeed.

Now, given the fact that everyone has debt, the following cause-effect relationship is true:

Even a small increase in interest rates has a big effect on the economy, consumptions and investments

This has huge implication for the economy, but before analyzing the impact, let’s check what is the FED view on current monetary policy.

FED Declarations

If you check the June 2019 meeting minutes, there is a ton on insights on what is going on and especially on how fast things are changing. If you are an investor, you can’t afford not to pay attention to this stuff and decide how to reposition your portfolio accordingly.

So, what to expect in the near future of monetary policy?

When talking about the outlook for monetary policy, “nearly all participants had revised down their assessment of the appropriate path for the federal funds rate over the projection period in their SEP sub-missions, and some had marked down their estimates of the longer-run normal level of the funds rate as well.

Many participants indicated that the case for somewhat more accommodative policy had strengthened. Participants widely noted that the global developments that led to the heightened uncertainties about the economic outlook were quite recent.

Many judged additional monetary policy accommodation would be warranted in the near term should these recent developments prove to be sustained and continue to weigh on the economic outlook

In other words, they are talking about stimulating the economy now, with unemployment at record low, after 10 years of expansion, with low interest rates and still a quite decent economic growth, in fact:

Several participants noted that a near-term cut in the target range for the federal funds rate could help cushion the effects of possible future adverse shocks to the economy

At this point, we shouldn’t have doubt about their intentions of lowering interest rates and keep the economy going. That is exactly what has been done in the last few decades and it is what brought debt to frighteningly high levels.

The Fed has historically needed to cut interest rates by 4 or 5 percentage points to combat recessions. But it’s currently setting them at 2.25 to 2.5 percent. That’s already too low, and if the Fed starts cutting now, it will have even less room to maneuver when the next downturn comes.

Playing this game of manipulating the economy through lower and lower interest rates brings to undesired consequence: the FED will eventually lose control over interest rates as they won’t be able to use this lever to further stimulate the economy through monetary policy.

Why should that happen?

In the years, debt was used to stimulate growth instead of increasing productivity, short-term debt cycles got bigger and bigger and now a huge long-term debt cycle towards its end is looming.

Central banks will lose control because they are acting against nature: the economy works in cycles.

When you create huge imbalances sooner of later they have to offset each others.

You can postpone the problem as long as you manage to do so, but eventually it will go back to a cycle and a recession shows up, inevitably.

What to Expect?

Debt is the key. We saw how small increases in interest rates have big effects on the entire economy.

In the 1960’s we had the same levels of interest rates as we have today, what happens now?

Two potential outcomes are the following:

  • They go up, causing a recession
  • They turn into inflation

Rising interest rates would mean causing the recession, but at the same time there is a limit for decreasing interest rates because you can’t go below zero, and this is where things are getting bigger:

The next step is money printing, if this happens, you will see inflation.

For those who have debt, inflation is actually a good thing because it makes it easier to buy debt, and since everyone has a high level of debt (Government, Businesses, Consumers) creating inflation would make a lot of sense, especially when the alternative is causing a recession.

What does it mean for our long-term investments?

Modern monetary policy is all about currency creation, in this process central banks will sacrifice currencies.

The first takeaway is that we should be careful with currencies: it is ok to keep some cash but remember that is better to use it to purchase good investments when opportunities arises.

The second, and most important takeaway is to be prepared for this kind of move. This involves creating a portfolio that involves real diversification and hedges, with good risk-reward investments and a long-term focus on the business.

Markets are always short sighted, the real problem looming is that our economy could be headed into a severe recession that will have negative impact on consumptions and corporate earnings.

It is not by chance that the FED always stress the rising uncertainty in the economy, nobody knows what will happen and things seems to be getting more and more fragile.

What we know is that central banks will do whatever they can to keep the economy going and to avoid recession. This involves printing more money and over the long-term it will have strong macroeconomics implications.

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