Reflecting on the Fed’s historical monetary actions

The soft landing narrative has gained traction, raising concerns about the economy facing a potential crisis. The Federal Reserve’s adherence to a “higher for longer” policy has left the economy exposed to mounting risks, particularly as economic data lags. Historically, when the Federal Reserve embarks on a series of interest rate hikes and yield curves invert, a recession follows. There are inherent risks associated with this strategy.

Yield curve inversions and the lag effect

Yield curve inversions typically manifest approximately 10 to 24 months before a recession or crisis event becomes evident. This delay is attributed to the “lag effect” of higher borrowing costs gradually exerting negative impacts on the economy. While the Fed anticipates rational behavior from individuals as it tightens monetary policy, market participants tend to behave differently.

Collision of debt

In the current economic landscape, the US is in the most highly leveraged era. This significant rise in leverage was enabled by nearly zero interest rates during that period. Given the financial system’s leverage, the collision of debt-financed activities with restrictive financial conditions is poised to stifle growth. Throughout history, such increases in financial conditions have consistently heralded the onset of recessions and crisis events, even at much lower levels of overall leverage.

The lag effect of yield curve inversions

While an inverted yield curve often prompts the media to predict an impending recession, the delay in its manifestation leads to assumptions that the timing for the next recession or crisis event could be in 2024. The “lag effect” has yet to materialize fully due to the considerable stimulus injected into the economy and sustained elevated money supply as a percentage of the economy.

Inevitability of a crisis event

The interplay of higher borrowing costs, diminished money supply, and slowing economic growth, although not yet resulting in a crisis or recession, does not negate the possibility of one emerging. As interest rates rise and the Fed tightens monetary policy, the economy’s momentum may temporarily defy financial gravity.

Still, the negative impact on a highly leveraged economy remains a real concern. While the exact timing of the next “crisis event” remains uncertain, it is only a matter of time until the “higher for longer” approach by the Fed punctures the “this time is different” narrative.

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