As the Fed continues to hike rates to fight an inflationary “boogeyman,” the more considerable threat remains deflation from an economic or credit crisis caused by overtightening monetary policy.
History is clear that the Fed’s current actions are once again behind the curve. While the Fed wants to slow the economy, not have it come crashing down, the real risk is “something breaks.”
Each rate hike puts the Fed closer to the unwanted event horizon. When the lag effect of monetary policy collides with accelerating economic weakness, the Fed’s inflationary problem will transform into a more destructive deflationary recession.
If we overlay periods of Federal Reserve tightening on our economic composite recession indicator, the risk becomes quite clear.
While the Fed is hiking rates due to inflationary concerns, the real risk becomes deflation when something breaks.
“Such is because high inflationary periods also correspond with higher interest rates. In highly indebted economies, as in the U.S. today, such creates faster demand destruction as prices and debt servicing costs rise, thereby consuming more of available disposable income.
Not surprisingly, each period of high inflation is followed by very low or negative inflationary (deflation) periods. For investors, these recessionary indicators confirm that earnings will decline further as tighter monetary policy slows economic growth.
Historically, periods of Fed tightening have never had a positive outcome on earnings, and it likely won’t this time either. That is particularly the case when the Fed “breaks” something.
While it may be different this time, I wouldn't bet on this view from an investment standpoint.
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