The Higher They Hike, The Further They Fall
Updated: Mar 15
It has been over a year since my last blog post on the state of the US economy. The US economy has seen the highest inflation in almost 40 years; the "transitory" inflation dream turned into a "persistent" inflation nightmare. The Federal Reserve has had to constantly re-evaluate their forecast of the economy; dramatically changing their tone from downplaying the fear of inflation to emphasizing their determination to fight inflation. For the Fed to convey the seriousness of their fight against inflation, they have increased the Fed Funds Rate at the fastest rate in history. The upper bound target of the Fed Funds currently sits at 4.50% and is expected to reach almost 5% in the first half of 2023.
The Fed has continually increased their forecast of where they expect the Fed Funds Rate will be at the end of 2023, starting from 1.5% at the end of 2021 to over 5% as of the end of 2022. Some of the "world's top economists" who look at data all day long were completely wrong.
Due to the Fed's lethargy on increasing rates in 2021, they have stomped on the monetary brakes in 2022. The short end of the yield curve has shot up causing much of the yield curve to either flatten or invert. The 2/10 Treasury spread is the most negative it has been since the 1980s. An inversion of the 2/10 Treasury spread has been a key recession signal for decades as it usually occurs prior to a economic downturn.
Many of the sectors of the US economy that saw the most growth following the COVID-19 pandemic have been hit the hardest by this early stage of the current downturn. Crypto has seen multiple failures and frauds; the biggest being the downfall of FTX. Even Bitcoin, the "gold standard" of crypto, has seen its value drop by over 60% from the 2021 highs.
There are many more things that can go wrong rather than right. The world economy is primed for an economic crisis. It is very likely to begin outside the United States. It could begin in China as they have a global impact and their monetary policies even make the US Federal Reserve blush. Then there is Japan, the originator of today's status quo monetary policy, which could be on the brink of losing control. The Ukraine-Russia conflict could turn much worse before it gets better. Central and South American countries have been ripe with economic and political turmoil. The dollar has only recently softened versus many other major currencies after this huge run-up. This dollar strength has challenged many multinational companies and foreign governments.
Current market forecasts of the Fed Funds Rate indicate that we will see the Fed cut rates in the 2nd half of 2023 and will be lower than today in 2024. With annual inflation starting to dip due to the math of high year-over-year comparisons, the Fed might get the economic cover they need to cut rates and reinstate QE. Although the Fed can be somewhat leisurely when raising rates, they have historically acted very fast in crisis to cut rates back to zero.
One of my favorite metrics to measure the current state of the US economy is the year-over-year growth in the money supply. M2 can be used for this, but I prefer to look at a modified metric pioneered by the Austrian School of Economics called the "True Money Supply" (TMS2). The growth rate of M2 and TMS2 have slowed to practically zero. This is the slowest rate of monetary growth in decades. Slowing of this metric is another indication that a recession is just over the horizon (red circles). An economy built on cheap money and excess liquidity struggles and breaks when the growth rate of money declines and liquidity begins to evaporate. 2023 will be a momentous year in financial history, so hold on tight!