Yesterday the Federal Reserve announced the beginning of the end for its bond buying program. When the pandemic grounded economic activity to a halt, the Fed started buying $120 billion in bonds each month ($80 billion treasuries & $40 billion mortgage back securities). The Fed has been using this tool called “quantitative easing or QE” since the 2008 recession. QE serves two purposes:

1. keeps long term interest rates low
2. keeps liquidity in the banking system

The Fed’s balance sheet – illustrated in the chart above – has now grown to $8.6 trillion, or roughly 36% of nominal GDP.

The plan now is to reduce the bond buying by $15 billion per month starting at the middle of this month. So $105 billion this month ($70 billion treasuries & $35 billion MBS). At this pace, the “tapering” will be completed by July 2022. And rate hikes should begin sometime in the 2nd half of 2022. The market now expects 1 rate hike next year, and about 65% chance for 2 rate hikes.

This was low hanging fruit and something they should have done a long time ago! This is not monetary tightening as some might call it. This is the Fed becoming less accommodative because emergency level stimulus is no longer required. Keeping this much stimulus in place can do more harm than good.

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The Fed also changed some of the wording regarding inflation. Up until now they always referred to inflation as being “transitory”, but yesterday they stated inflation is “expected to be transitory”. Meaning they are hedging their bets a bit and not as confident that inflation will go back to normal anytime soon. Something I said last year.

The Fed is either being extremely naïve or they don’t want to admit their role in the current challenges. The above chart shows the latest annualized growth rate in the money supply (M2) came in at +12.8%, which is lower than the +25% annualized growth rate of earlier this year, but still well above the historical averages of +6-7%. Inflation won’t moderate until M2 growth drops below average.

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It’s not just the jump in M2, current monetary policy means “cash is trash”. The above chart shows the Fed Funds rate (benchmark for short term interest rates) minus the annualized total CPI, what is called the “real Fed Funds rate”.

It’s currently at -5.3%, meaning the cost of living is increasing 5.3% more than the income on short term cash investments. Since the dataset began in 1954, cash has never been more unattractive. And the only other times it was this bad was in 1975 and 1980. But here is the key difference between then and now, back then it was a policy response at the end of a recession, whereas today we are in the 18th month of an expansion.

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Even fixed income is equally unattractive. The 10 year treasury bond rate minus the annualized total CPI is also deeply negative. The cost of living is rising by almost 4% more than the income on a 10 year treasury right now.

People ask me why I have been bullish on stocks despite all the challenges. Part of it has been earnings of course, but the other part is because of how unattractive fixed income is as a long term investment. (Note: all near term cash flow needs should still be in bonds/cash. My general rule of thumb is any money needed within 5 years should be out of the market). If stocks are overvalued, then bonds are ridiculously overvalued. There Is No Alternative (TINA) to stocks in this environment.

Needless to say I’m glad the Fed is reversing course but they should have done it a long time ago. They continue to underestimate their role in this inflationary environment. Yes, supply chains are strained because you just can’t turn the economy off and on like a light switch. But part of the reason why supply chains are strained is because of the sharp spike in demand. And a reason for the demand spike is because of what we discussed; increasing the money supply and monetary policy effecting making cash and fixed income worthless.

Hopefully the employment picture will get better (which should alleviate some of the production issues) and the Fed will normalize policy (which should alleviate some of the excess demand issues), resulting in moderating the inflation threat. This was a step in that direction but we still have a long way to go.