The reverse wealth effect

The Federal Reserve announced it is going to be tightening up monetary policy, raising interest rates and stopping quantitative easing. But will this really happen?

There are sincere doubts. Normalizing rates and stopping QE for any period longer than a few months would cause a lot of uncertainty in the financial markets. Stock and property prices would almost certainly dive. You could probably count on a fall of 50% in stocks and home prices would fall precipitously as the mortgage rates move higher. And there’s a chance that higher rates won’t even actually help much with inflation.

But the effects of tightening monetary policy would irreparably harm the precious wealth effect. That’s the excuse the Fed has been using since more than 10 years to fuel the money printing machines. If stocks and homes increase in value, people will spend more. The famous “wealth effect” creates a non-virtuous cycle. But if QE and low rates create a miraculous wealth effect, what happens when the opposite happens? We probably could call it it the “reverse wealth effect” because spending should collapse and overly indebted companies would struggle to pay off or refinance their debt, and most-likely fail.

If the Fed did somehow raise interest rates to 5% or 6%, the interest expenses on U.S. federal debt would balloon, too. The US is already paying $562 billion per year on interest on debt. Imagine the interest payment burden when interest move to substantial higher levels?

So, in my opinion, there are only 2 ways out of this mess:

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, postpone all problems with more money printing, keeping zombie companies alive and eating away at everyone’s savings.

As hard as it is, but alternative 1. is the more sustainable. It would cause a much-needed reboot of the economy. For a few years, it would be extremely hard but we’d have a fresh start to rebuild upon.

Unfortunately, the more realistic scenario will be that the Fed will try to tighten, fail, then start printing money again. The markets will love it and also people do not don’t favour an economic reboot, even if it’s needed. They want the old comfortable system to continue. So, just expect more money printing and kicking the can down the road in the years to come.

Sven Franssen