The FED Has Backed Itself Into a Corner. Can They Get Out of It Safely?

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The recent federal reserve meeting had spooked investors and had caused markets to tumble. Will the bubble pop when the fed raises interest rates?

The Federal Reserve building in Washington DC

When the fed meeting took place last week investors were waiting with bated breath to figure out what would be the outcome of the meeting. Markets had started tumbling downwards in the week prior to the meeting, expecting the worst. When FED chair Jerome Powell finally came out and held his press conference the next day, the markets let out sighs and made some marginal gains. The Federal Reserve would keep interest rates the same up till March at the very least. They would be tapering their asset purchase scheme for now though. All is well for now.

Interest Rates and the Economy — How it works?

Interest rates function like valves that control the money supply. When interest rates are raised, credit becomes more expensive and the money supply becomes tighter, which in turn hampers growth and economic activity. When interest rates are lowered, credit becomes cheaper, money supply increases and it spurs economic activity.

Interest rates are used to control the economy and keep it stabilized and running, at least ideally. Whenever there is an economic downturn, the fed lowers interest rates in order to encourage economic activity and stave off recessions or growth slumps. When there is inflation, the fed raises interest rates in order to tighten the money supply so that less money is circulating in the system.

But over the years the fed, with its policy shaped by corrupt bureaucrats and politicians has seen interest rates being lowered and kept at those low levels for long periods of time. This is mainly done to provide cheap credit to Wall Street and enable Congress to borrow money at cheap rates to run the bloated government bureaucracy that is in dire need of restructuring.

Market Correction or Super Bubble Bust?

The stock market and the general economy undergoes boom-bust cycles. There are periods of growth followed by periods of economic downturn where the market crashes and or undergoes correction to deflate the bubbles that had formed during the growth stage. On average it happens once a decade or so. But in recent years, the crashes have become stronger in intensity, with the 2008 crash resulting in a recession.

US Interest rates for the last 60 years. Apart from period upswings, the graph has steadily been decreasing over the decades and remaining flat for the last decade.

Interest rates are used as a tool to control these upswings and downswings and stabilize the economy. But unfortunately, over the last few decades the fed has kept on lowering interest rates and keeping them in that manner for the above mentioned reasons. This in turn has caused cheap money to flood the markets, drive up inflation and cause inflated asset classes. If you are wondering why people are selling each other pictures of cartoon monkeys for millions of dollars, here is the reason. The insanely low interest rates, combined with the fed purchase of distressed corporate bonds have also resulted in a lot of zombie companies being propped up. Currently the asset prices are inflated in all sectors of the market. But it is most evident in sectors like tech, real estate, crypto and NFT markets, etc.

Damned If You Do, Damned If You Don’t

The fed has backed itself into an impossible position as a result of this corruption and incompetence. Inflation is high and rising, causing public anger unrest and quite possibly stagflation. In order to control it, they will have to raise interest rates. But unfortunately, all the dirt cheap money over the last two years has caused the build up of multiple asset bubbles which could all collapse together or one after the another when they raise the rates.

This can in turn cause a large recession (of the order of magnitude of the great depression era), and the fed cannot do anything now as interest rates have been kept so abysmally low for too long that they cannot lower it further. There is also the possibility of a US government bankruptcy, as even a 1% increase in the interest rates will cause the government's annual interest rate payments to rise up to $1 trillion from the current $350 billion. Overall, whatever the course of action taken, the decade ahead seems to be a painful one and one that will cause a monumental change in our global financial systems to work due to the US dollar's position as the global reserve currency. All eyes are now on the FED and their March 2022 meeting.