The Fed Should Prepare Markets for Tightening

The Federal Reserve should prepare markets for tightening, the lifting of short-term interest rates to fight inflation.

That wouldn’t be easy, given the market valuations, investor addiction to low-interest rates, and the fears of a stalling recovery.  (See Insiders’ Hot Stocks on TipRanks)

Inflation Is Turning Permanent

For over a year, financial markets subscribed to the Fed’s theory that soaring commodity prices is a temporary phenomenon caused by the slow response of the supply side of the commodity market to a sharp pick-up of the demand side due to the opening up the world economies.

This theory has been challenged in recent months as commodity prices continued to soar. For instance, retail inflation rose at an annual increase of 6.2% in October, the highest since November 1990, and ahead of market forecasts of 5.8%. Wholesale inflation stayed at 8.6% in October, the same as in September, and the highest since November 2010.

The persistently high inflation for a long time means that the old villain of the American economy is turning from a temporary to a permanent problem, requiring decisive action by the nation’s central bank to fight it.

Tapering isn’t Enough

Already, the Fed has announced that it will begin to taper its bond-buying program at the end of November, slowing down the pace it puts money in the economy.

That isn’t enough to fight inflation numbers north of 6%, three times its official target. It needs more drastic action, like tightening, taking money out of the economy. That would undoubtedly slow down the demand for commodities and eventually bring inflation down, but it won’t be easy.

Preparing Markets for Tightening Won’t be Easy

While cutting interest rates is an easy thing to do, raising interest rates isn’t. They increase the cost of money, make investing in risky assets less appealing, and often cause sudden corrections when valuations are overextended, and investors are addicted to cheap money. That’s why it’s hard for the Fed to prepare markets for tightening.

Compounding the Fed’s problem is that the U.S. economy shows signs of stagflation, a situation of high inflation combined with an economic slowdown. That’s evidenced by Friday’s Michigan Consumer Sentiment report, which showed a significant decline in consumer sentiment, and the Michigan inflation expectations, which remained elevated.

The Bottom Line

Preparing markets for tapering in the face of stagflation was a tough job. Preparing them for tightening would be even more challenging.

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