Early Investing

The Fed’s Policy Tightening Mirage

The Fed’s Policy Tightening Mirage
By Adam Sharp
Date January 21, 2022

Bitcoin is “crashing” once again. As I write this, it’s trading around $39,000. It’s down from around $43,000 a week ago. Altcoins are correcting much more severely, with many down 15% over the last 24 hours. 

As usual, all the crypto traders on Twitter are freaking out. They’re in a full-blown panic over a move that is very common for bitcoin. Probably because they’re using too much leverage, as I discussed back in November. 

For those who are just holding tight, you’re doing the right thing. Do not get drawn into the “crypto trader” lifestyle. It doesn’t work out for most people — I’d say 90%.

Altcoins have been on an absolute monster tear for the past year-plus. Binance Coin (BNB), for example, is up from $40 a year ago to $423 today. Solana (SOL) is up from around $3 to $123 over the same period. So a few -15% days should surprise no one. And altcoins may have further to go on the downside. Bitcoin may have more short-term downside as well, but it will almost certainly go down a lot less than altcoins if crypto does continue to fall. 

The Fed’s Normalized Mirage

Why is this happening? First of all, these types of corrections are perfectly normal in crypto. But it’s also happening because we’re entering a period when, supposedly, the Federal Reserve is going to be tightening up monetary policy. Fed officials claim they’re going to be raising interest rates and stopping QE (quantitative easing), which could be bad for alternatives like bitcoin. If people could earn 5% on their savings accounts, there’d presumably be less demand for crypto.

For the average investor who follows mainstream financial news, this must be a scary prospect. We’ve been repeatedly told that the central bank is serious this time. It has to deal with inflation. Rates must go higher, QE must end!

But I highly doubt it will happen. I really don’t think most people realize what that would involve. Normalizing rates and stopping QE for any period longer than a few months would cause a massive crash.

Stock and home prices would almost certainly dive. I’d say at least a 50% fall in stocks is possible if the Fed does proceed with tightening and holds the line. Home prices would fall precipitously as the mortgage rates shot higher. And there’s a chance that higher rates won’t even actually help much with inflation.

Will Fed Chair Powell be able to withstand the pressure? 

The Reverse Wealth Effect

Tightening monetary policy would irreparably harm Ben Bernanke’s precious wealth effect. That’s the excuse the Fed has been using since 2010 to prime the pump. If stocks and homes increase in value, people will spend more. That’s Bernanke’s legacy, the famous “wealth effect.” It creates a sort of non-virtuous cycle. But it (sort of) works, at least for the wealthiest Americans.

If QE and low rates create a miraculous wealth effect, what happens when we reverse them? The reverse wealth effect. Spending would collapse. Overly indebted companies would struggle to pay off or refinance their debt, and most would likely fail. 

And if the Fed did somehow raise interest rates to the 5% to 6% range, the interest expenses on U.S. federal debt would balloon. We’re already paying $562 billion per year of interest on our debt. What would it look like in five years, as we continue to issue trillions in new debt per year? We’d soon be paying more than $1 trillion in interest payments alone!

In my view, it boils down to two choices.

  1. Tighten monetary policy, crash the economy temporarily, then start fresh after a few tough years.
  2. Allow inflation to run hot with low interest rates, keeping zombie companies alive and eating away at everyone’s savings.

As hard as it would be, I would prefer the first option. It would cause a much-needed reboot of our economy. For a few years, it would be extremely hard. But then we’d have a fresh start to rebuild upon.

But I’m pretty darn sure our short-sighted elected officials and central banks will not make the same choice.

My view continues to be that they will try to tighten, fail, then start printing money again with renewed vigor. The markets will cheer. The vast majority of Americans don’t want an economic reboot, even if it’s needed. They want the old comfortable system to continue. And the way to do that is to keep propping it up by printing money.

For more on this topic, check out these Early Investing articles:

Top Posts on Early Investing