FRB Hangover | July 13, 2018

Man, can the Federal Reserve Board (FRB) throw a hell of a party!  9 years and we are still not feeling the hangover; when will it come?

A decade ago the FRB reduced interest rates to the zero bound.  They also managed to build a hefty balance sheet, $4.5T; all in an effort to get the party started.  They slashed rates making borrowing cheap while buying treasuries like crazy in an effort to infuse cash into the system.  All of these efforts to reinvigorate the economy after the financial crisis came at a cost. That was always known. What was not known (and still very unclear) is at what total cost.

After Quantitative Easing 1, 2, and 3, the FRB strategically began raising rates and lowering their balance sheet. They hope to lower the balance sheet to pre-crisis levels and raise rates high enough to be effective during the next recession. The problem is their fiscal tightening, which may have started too late in fact, may be the catalyst to the next recession, AKA, our hangover. As rates rise, the yield curve flattens and that increases the risk of a recession. The decreasing size of the balance sheet is not moving fast enough to be effective given the likely timeline to the next recession.

The answer to the current risks is an accelerating economy. These risks we face are the very structure built to protect it. As a result, strength in spending (thanks to fiscal stimulus, tax reform) will help pace the tightening monetary policy of the FRB. Tariffs crimp the effects of tax reform, but as of now the impact is minimal enough to keep a recession at bay… for a little while.

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