Jim Rickards: SEVERE Market Drop Coming Sooner Than Later Will Cause The Fed To Flip-Flop

by Jim Rickards via Daily Reckoning

The Federal Reserve, under new chairman Jerome “Jay” Powell, raised the federal funds target rate 25 basis points today. It was Powell’s first significant move as the new chairman of the Federal Reserve.

Let me first give my opinion of Jay Powell before weighing on the implications of today’s decision.

I worked with Jay Powell when he was at the U.S. Treasury and I was general counsel of a major primary dealer in government securities. The primary dealers act as underwriters at auctions of U.S. Treasury securities, so in effect, Jay was my firm’s biggest customer.

My impression of him was that he was highly professional and always acted in the best interests of the Treasury and the taxpayers. He’s smart, has integrity and has had a distinguished career both in public service and in a private capacity at investment funds and think tanks.

Jay Powell is someone who is well liked and well regarded by Republicans and Democrats equally. That’s a rare attribute in today’s deeply partisan political scene.

The most important fact about Jay Powell’s chairmanship is that there will be no change in monetary policy. As a Fed governor, Powell never voted against Janet Yellen on any interest rate policy decision.

His speeches always voiced strong support for Yellen’s approach. In short, Powell is, and will continue to be, “more Yellen” when it comes to Fed interest rate policy. The Fed chair has changed, but interest rate policy has not.

Beginning in December 2015, Janet Yellen put the Fed on a path to raise interest rates 0.25% every March, June, September and December, a tempo of 1% per year through 2019, until the Fed “normalizes” interest rates around 3%.

The only exception to this 1%-per-year tempo is when the Fed takes a “pause” in hiking rates because one part of its dual mandate of job creation and price stability is not being met. Lately job creation has been strong, but the Fed is facing head winds in achieving its inflation goal.

The Fed is targeting a 2% annual inflation rate as measured by an index called PCE core year over year, reported monthly (with a one-month lag) by the Commerce Department.

That inflation index has not cooperated with the Fed’s wishes and is still well below 2%. Both December and January’s reading came in at 1.5%.

This undershooting has been a persistent trend and should be troubling to the Fed as it contemplates its next policy move at the FOMC meeting on June 12-13.

But the Fed’s bungling should come as no surprise. The Federal Reserve has done almost nothing right for at least the past twenty years, if not longer.

The Fed organized a bailout of Long-Term Capital Management in 1998, which arguably should have been allowed to fail (with a Lehman failure right behind) as a cautionary tale for Wall Street.

Instead the bubbles got bigger, leading to a more catastrophic collapse in 2008. Greenspan kept rates too low for too long from 2002-2006, which led to the housing bubble and collapse.

Bernanke conducted an “experiment” (his word) in quantitative easing from 2008-2013, which did not produce expected growth, but did produce new asset bubbles in stocks and emerging markets debt.

Yellen raised rates in a weak economy, and now Jay Powell has done the same.

But what happens now?

I’ve warned repeatedly that the Fed is tightening into weakness. The Atlanta Fed, known for its rosy projections that are almost always revised downwards once the data come in, has once again lowered its estimate of first quarter growth from over 5% to 1.8%

Both Goldman Sachs and JP Morgan have also revised their forecasts lower. The economy has been trapped in this low-growth cycle for years. The current economic recovery shows none of the 3% to 4% growth that previous recoveries have shown.

Meanwhile, the Fed is plowing ahead with its policy of quantitative tightening (QT), or cutting into its balance sheet.

The Fed wants you to think that QT will not have any impact. Fed leadership speaks in code and has a word for this which you’ll hear called “background.” The Fed wants this to run on background. Think of running on background like someone using a computer to access email while downloading something on background.

This is complete nonsense.

They’ve spent eight years saying that quantitative easing was stimulative. Now they want the public to believe that a change to quantitative tightening is not going to slow the economy.

They continue to push that conditions are sustainable when printing money, but when they make money disappear, it will not have any impact. This approach falls down on its face — and it will have a big impact.

Contradictions coming from the Fed’s happy talk wants us to believe that QT is not a contractionary policy, but it is.

My estimate is that every $500 billion of quantitative tightening could be equivalent to one .25 basis point rate hike. Some estimates are even higher, as much a 1.0% per year. That’s not “background” noise. It’s rock music blaring in your ears.

The decision by the Fed to not purchase new bonds will therefore be just as detrimental to the growth of the economy as raising interest rates.

Meanwhile, retail sales, real incomes, auto sales and even labor force participation are all declining or showing weakness. Every important economic indicator shows that the U.S. economy can’t generate the growth the Fed would like.

When you add in QT, we may very well be in a recession very soon.

Then the Fed will have to cut rates yet again. Then it’s back to QE. You could call that QE4 or QE1 part 2. Regardless, years of massive intervention has essentially trapped the Fed in a state of perpetual manipulation. More will follow.

But what about the stock market?

Despite last month’s correction, the stock market is overpriced for the combination of higher rates and slower growth.

The one thing to know about bubbles is they last longer than you think and they pop when you least expect it. Under such conditions, it’s usually when the last guy throws in the towel that the bubble pops. Last month’s correction took some air out of the bubble, but the dynamic still applies. It just extended the timeline a bit.

But is this thing ready to pop for real?

Absolutely, and QT could be just the thing to do it. I would say the market is fundamentally set up for a fall. When you throw in the fact that the Fed continues to have no idea what they’re doing and has taken a dangerous course, I expect a very severe stock market correction coming sooner than later.

The Fed is going to find out the hard way that raising rates and reducing the balance sheet will slow the economy. I believe that will ultimately lead to another flip-flop and the Fed will once again loosen.

When the market sees that the Fed has decided to flip from tightening to an easing policy, look for increased volatility — and more corrections.

The dollar will sink and gold will rally. Do you have your gold yet?

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