Will the FED sacrifice the stock market or the dollar? In the face of so much monetary stimulus, some people may claim that the Fed has two choices: 1) keep printing trillions and let inflation skyrocket or 2) tighten monetary policy and watch the stock market crash.
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I'd like to present a third alternative, the alternative that shows that neither will be necessary : The printing will stop AND the economy will be able to support a tightening of monetary policy. M2 is loosely correlated with inflation. Therefore, we must consider more factors than just the amount of dollars in circulation, such as supply and demand. I believe that the prime cause of inflation stems from the imbalance in S&D. Supply is subject to so many factors like geopolitical and environmental factors such as lockdowns. As you can see, global supply chains have never seen this much pressure before. This dynamic allows businesses to increase their prices due to scarcity. Looking into the future, I think that it's safe to assume that supply chain issues will subside. This will add deflationary price pressures into the mix. However, due to price stickiness, some categories of goods & services will not deflate. It's on a case by case basis. For instance, the prices of commodities will likely experience downside price pressures. Whereas rents and the prices of software subscriptions will not. Right now, the biggest risk to inflation is supply chain issues coming from China in my opinion.
In normal times, demand has generally predictable levels of elasticity. However, the pandemic skewed everything. Due to lockdowns and stimulus, people were unable to spend their money, leading to pent up demand. Once unleashed, without being met by the equivalent supply, the demand created immense pricing pressure, causing inflation.
With the savings rate finally coming back to normal levels, demand has been unleashed. Now that saving rates are low, will demand continue to be so high? The velocity of M2 is a measurement of the rate at which money is exchanged in an economy. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions. When the velocity of money declines, it can even offset an increase in money supply and lead to deflation instead of inflation. As you can see, the velocity of money is at the lowest point in the last 45 years. With mobility already declining by more than 10% in the past two months, Omicron won't make the velocity of M2 go up, that's for sure
The reverse repo market is an indicator of how much excess liquidity is held by the banks. As we all know, to combat inflation, the Federal Reserve plans to tighten, which will create a less favourable backdrop for growth stocks, tempering investor enthusiasm and making it more expensive for companies to fund growth through debt. The question is, will the economy crumble under contractionary fiscal policy? Will this crash the stock market or not? I’d be surprised that the FED actually goes through with all of the expected rate hikes. By many accounts it seems to me that inflation is on its way to calming down, which will remove the need to raise rates. At that point, the risk on capital will likely flow back into the growth sector. Unless we see mega caps sell off another 50%, the quickest stocks in the market to rebound will be the small caps.
#crash #stockmarket #correction
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