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What Are the Consequences If the Fed Overtightens?

It is not entirely out of the realm of possibility that the growth of M2 will go negative.

The World Bank’s annual Global Economic Prospects report forecasts that worldwide economic growth will be 3.1% in 2018. That figure breaks down to 2.2% in developed economies and 4.5% in emerging-market and developing economies.

Those numbers aren’t much different from others, but I bring them to your attention because the World Bank also suggests that we should get used to global growth in the 3% ballpark because it may be stuck there awhile.

They believe global output is now approaching its maximum capacity, constrained by rising interest rates and full employment.

The Causes of Constrained Growth

These factors are the result of demographic and political forces.

The world population is aging rapidly, and governments are not well prepared to support large numbers of retirees—nor are the retirees prepared to support themselves.

The populations of many countries are actually shrinking. Assorted barriers prevent labor and technology from migrating to the places where they can produce the most output.

Unless something changes, the World Bank thinks the global economy will grow more slowly going forward than it has in the last 20–30 years—much as we’ve seen happening in the US the last few years.

Of course, 3% growth isn’t disastrous. It is far better than the subzero growth phases (i.e. recessions) we’ve come to expect every decade or so. We don’t need the great years as much if we have fewer bad ones—but I doubt the central banks will give us that happy outcome.

They have models to follow.

Add constrained growth to the global picture and it looks less attractive. If the World Bank is correct that we’re near maximum output, nothing the Fed and its peers do will help very much. But they can still do things that hurt, and they almost certainly will.

What might those missteps look like? You may already know.

Tightening Too Much and Too Fast

If the Federal Reserve insists on raising interest rates in this environment, while reducing their balance sheet and slowing the growth of M2 and the monetary base, they will tighten far more than by simply raising rates 75 to 100 basis points.

A lot of factors go into the monetary base.

When the US Treasury deposits or removes money from its account at the Fed, that changes the monetary base. When you take money out of your bank and/or put it in, that affects the monetary base.

Same for large corporations. The monetary base is an exceptionally noisy set of data. But in general, we can see that each Federal Reserve rate hike has reduced the monetary base by about $50 billion over time.

If the Fed’s tightening trend continues (and there are very good reasons to think that it could actually increase), we could see another $150 billion reduction in the monetary base.

Getting $420 Billion off the Balance Sheet

Further, the Fed is going to reduce its balance sheet $60 billion this quarter, $90 billion in Q2, $120 billion in Q3, and $150 billion in Q4.

They have already said they are not going to discuss that issue further in FOMC meetings, so those amounts are baked into the cake. That is an additional $450 billion out of the monetary base.

I’m not going to get too wonkish on you here, but those reductions in the monetary base are going to have an effect on the M2 money supply. The growth rate of M2 is already down from its normal 7% to around 2%.

The Fisher equation basically tells us that GDP is equal to the money supply times the velocity of money. It is not entirely out of the realm of possibility that the growth of M2 will go negative. Unless there is a corresponding increase in the velocity of money (something we have not seen for a long time), that negative monetary growth could spell an actual recession.

Watch the Fed, M2, Velocity of Money, and the Yield Curve

The moves the Fed is making are flattening the yield curve.

With all of the monetary background noise that I’ve been detailing, it is not entirely clear that the yield curve will remain positive.

The Federal Reserve seems unconcerned that quantitative tightening will have the opposite effect that quantitative easing did. I have seen no work or research from the Federal Reserve on that topic.

I know I have said this before, but I just don’t see the fire that the Fed is so intent on putting out. I can understand their reasoning for raising rates, but I don’t understand why they have to reduce their balance sheet at the same time.

The factors I’ve reeled off are not going to produce a recession in 2018 (at least I don’t think so), because monetary policy acts with a long lag time. But Republicans are not going to be very happy if they see a recession in 2019 or 2020, as there will be no time to make any corrections before the 2020 election, and they will get blamed.

That you can take to the bank. And Trump won’t be able to pass the blame to the Fed, because it will be a Fed that he appointed.

So I still think we approach 2018 feeling relatively optimistic—but just watch the Fed, the yield curve, the velocity of money, and M2. It is not entirely out of the question that the Fed might reverse course and decide we don’t need as much tightening as they had planned on.

I keep trying to figure out where all this inflation is going to come from.

Maybe from energy prices in the short term, but wage inflation? That just doesn’t appear to be happening yet. Let’s hope it does—higher wages would be a good problem to have.

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Sharp macroeconomic analysis, big market calls, and shrewd predictions are all in a week’s work for visionary thinker and acclaimed financial expert John Mauldin. Since 2001, investors have turned to his Thoughts from the Frontline to be informed about what’s really going on in the economy. Join hundreds of thousands of readers, and get it free in your inbox every week.