The Fed's Options: Inevitable Economic Disruptions
Erik McCurdy | Jun 19, 2013 12:07AM ET
The final, speculative phase of the cyclical bull market in stocks that began in early 2009 continues to unfold in typical fashion. The uptrend has “gone parabolic,” accelerating into an unsustainable advance that will almost certainly be followed by a correction of equally violent character.
The development of every bubble requires that the conventional mindset believe firmly in some type of profoundly faulty premise. In 2000, the premise that accompanied the dot-com boom was that the economy had achieved some type of mythical “plateau” and, as a result, major economic disruptions were a thing of the past. In 2007, the premise was that the real estate market had become a “no lose” proposition. Today, the faulty premise is that the Federal Reserve can continue to drive risk assets such as stocks higher without any meaningful long-term cost to structural economic development. The mainstream view has come to believe that Federal Reserve stimulus is some type of magical pixie dust that can drive the stock market higher indefinitely without any significant consequences. Unfortunately, nothing could be further from the truth. As with all bubbles, the current speculative advance will end very badly for the market. The following graph from the Hussman Funds website displays our current predicament resulting from the historic amount of Federal Reserve stimulus that has been injected during the past several years.
There is always a significant cost to implementing an extreme solution to a perceived problem, and the more extreme the solution, the more extreme the cost. As noted on the graph, the normalization of Treasury bill yields to 2 percent from current levels could be achieved in roughly three different ways. The only economically painless solution to this huge problem would be approximately 14 years of 5 percent GDP growth. Given the structural economic weakness that continues to exist due to, among other things, excessive debt levels, the likelihood of the painless solution is infinitesimally small. Therefore, we are left with two realistic scenarios. Either the country experiences massive inflation or the Federal Reserve embarks upon the largest monetary tightening in US history.
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Both of the plausible possibilities would cause severe economic disruptions, so there is no easy way out of this mess, contrary to what conventional thought continues to believe. Granted, limiting our possibilities to three distinct courses of action oversimplifies the situation, but this thought experiment accurately reflects the magnitude of the challenge we are facing. For now, mainstream analysts sing a happy song of unending stock market gains, but the music will invariably stop at some point, it is simply a matter of time. As always, the judicious study of market data will tell us when the forthcoming long-term top is likely in place.
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