Why The Fed Rate Hike Was A Mistake, But The Economy Has A Buffer

by: Matthew Allbee

Summary

The Fed raised rates to stem possible, future inflation and deflate possible asset bubbles from cheap money.

But the economy is different than what Fed economists are used to. There is reason to believe inflation is not going to rise drastically over the medium-term.

With this in mind, the Fed may have hearkened the beginning of a mild recession with this hike.

Down Markets have been tumbling since the start of the year for a number of reasons: the U.S. "earnings recession," fears about a Chinese slowdown, and fears about falling oil prices. This tumble came just weeks after the Federal Reserve raised interest rates for the first time in nearly a decade. With some believing markets may continue to fall as conditions continue to get worse, many believe the Fed will be forced to reverse course after finding the rate hike was a mistake.

The Fed made this decision in hopes to calm future inflation, as well as to deflate asset bubbles that may begin to form when money is kept abnormally cheap. While the inflation rate has been in a downtrend since at least 2008, besides a short and sharp growth in prices in 2009, the Fed is worried that this trend is now coming to an end. With such a large expansion of the money supply from fighting the financial crisis and it's aftereffects, they believe that inflation could spike above their 2% inflation target if they wait to long.

This is based on the misguided concept that the economy is set to improve further, though. The macroeconomic concepts that Fed economists have been working with for years no longer exist.

Click to enlargeAs an example, let's look at the velocity of money. This key determinant of inflation, which measures the speed with which each dollar circulates through the economy, has been falling since 1995. Since this time, inflation has never risen above 6%, a number it frequently exceeded in the 1980's when velocity was rising and about 33% higher than it is now. Although the money supply has grown significantly, consumers and businesses are spending it slower and slower. This means that monetary stimulus will have a weaker effect, which could be the reason why inflation has remained so low.

Jobs gives similar worries. With the most recent initial jobless claims figure at 284,000, it has now fallen to levels that have been bottoms for the figure since the 1970s. This could be a sign that businesses are becoming overexpanded, and may soon have to begin laying off people as they shrink. With businesses shrinking, it is more likely that inflation will weaken in the future than strengthen.

With that being said, the next U.S. recession is likely to be a mild one. Of the money that was poured into the economy through expansive policy, much of it was funneled into the financial markets; away from the "real" economy. This is evidenced by the strong growth of the financial markets while economic growth remained anemic. As recession signals start to deflate these markets, this money may flood onto main street and stop any serious declines from occurring.

By getting in before the economy begins to sour, there are plenty of places where money can be made. As always, you can take advantage of the specific conditions of today's economy to maximize your returns.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.