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The FED Moves the Goal Posts - Again

August 31, 2020

Last week at the Federal Reserve “meeting” in Jackson Hole (actually done remotely via Zoom) much of the discussion revolved around the Fed “mandate” of institution/initiating/managing 2% inflation. We put quotes around “mandate” because the purpose of the Federal Reserve continually changes over time and we can find no record of Congress ever legislating that the Fed should have an official inflation target. From the Richmond Fed’s own website, we found this gem…

Since 1977, the Federal Reserve has operated under a mandate from Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates" — what is now commonly referred to as the Fed's "dual mandate."

We’re not really sure how the initial part of that statement constitutes a “dual” mandate considering there are three variables listed or where it has been written that the Fed should compile a balance sheet of $7 trillion by actively buying assets including corporate junk bonds. But regardless of our opinions, the FED keeps marching along and changing the rules as it sees fit. January of 2012 is when the Federal Reserve under the supposed leadership of Ben Bernanke initiated its 2% inflation target. The Fed decided that an effective inflation rate for the basic consumer economy as defined by woefully inaccurate measuring systems would be 2% (of course after “hedonic” adjustments which are yet another arbitrary calculation.) Why 2% inflation you ask? Well, that is a good question and it has never been answered. Our opinion is because it can’t be answered – a 2% inflation target is completely arbitrary and, in our observation, absurd. We thought that it had been settled - centrally planned economies, prices – well, pretty much centrally planned anything is not a good strategy. We will never be convinced that a room full of academics (most Fed governors don’t spend much time working in the real economy) can set prices of anything in a more effective and accurate manner than the hundreds of millions of participants in free markets. Centrally planned economies over all human history proved inefficient and susceptible to meltdown. Alas, the central planning in the world’s largest economy – the US – has recently shifted into overdrive.

So now our fearless leaders at the Fed have decided that a 2% inflation target should be shifted to some sort of a running average of 2%. Meaning that because inflation by their measure hasn’t constituted 2% for many years (thinking inflation has been benign makes us think they haven’t bought any bonds or stocks recently – or had any health care expenses – or had any kids that need to go to college – or bought any vacation homes or…) that going forward we can tolerate higher inflation in order to catch up.  We don’t want to go too far off on a tangent describing how stupid that is, but here is some quick economics 101. Deflation happens in free markets. Especially in markets with such rapidly changing technologies like we have now, there will be some SERIOUSLY misallocated resources that, in a deflationary wash-out will get effectively reallocated. Well, our fearless leaders at the FED were out sick when that was discussed in  Economics 101 for freshmen, so they have determined that deflation should not happen and inflation should in fact be 2% per year (or higher if we need to catch up.) The Fed’s primary mechanism to initiate inflation is to pin short-term interest rates to zero. That encourages families, companies and every level of government organization to load on more debt – which has been proven to be deflationary and perpetuates the problem. Consider this, because of these interest rate manipulating mechanisms of the Fed (rather than letting the marketplace determine interest rates) the number of “zombie” corporations in America has rocketed higher. Nearly one in every five publicly traded U.S. companies is a zombie, according to data compiled by Deutsche Bank Securities.

Meaning, 20% of our publicly traded companies are losing money. They only survive and are able to continue destroying capital because they have enough cash flow to warrant borrowing more money at these absurdly low interest rates.

Recently we ran across some writings of Rabobank's Philip Marey and found this point spot on…

The much deeper problem for the US economy is the asymmetric impact of Fed policies on households and businesses. The Fed’s monetary and regulatory policies have contributed to a form of capitalism where the rewards are going to the 1% and the risks are borne by the 99%. The current crisis response has made it painfully clear again that the Fed’s policies benefit high income individuals and large corporations, while small businesses and low income individuals bear the burden. While the Fed likes to see itself as part of the solution to America’s economic problems, it should ask itself whether it is also part of these problems.

So if things aren’t bad enough on the monetary side of things, then let’s take a quick look at the fiscal side of things. No one knows for sure, but it appears that the Federal Government’s deficit this year will be approximately $4 trillion – and total debt will print over $27 trillion by the end of the year.  So we don’t lose a sense of proportion here, in the ENTIRE HISTORY OF AMERICA UP TO 1980 the aggregate debt of the United States was $1 trillion. We have blown out 4 times that much in eight months. Government spending has gone “hockey stick” – take a look…

To be fair, the chart you are looking at is not just Federal government spending – but state and local as well – but government spending now constitutes roughly half of our economy.  Karl Marx is giggling in his grave…

Figuring out what this means for investors like us going forward is where the rubber meets the road. It is very scary that so much of the economy is dependent on continual government support – of course we don’t know how long that can last. However, we don’t want readers to draw the conclusion that we think the stock market is going to melt down soon. What the Fed is telling us, basically that they won’t raise interest rates anywhere in the foreseeable future – is very supportive of the stock market. The problem is that the economic support of the stock market isn’t really there (especially when you consider covid relief funding coming to an end) and with the risk of the election coming in November – which we don’t think ANYONE really has an idea what will happen market-wise around that.  Some stock exposure is fine, some cash for upcoming opportunities is fine. Find places to sell bonds and bond funds as the rewards of owning don’t match the mounting risk and as we always say – don’t sell your gold.

Regards and good investing!