The Easy Money Party Continues.  The Morning After will be Painful.

Last week, the Federal Reserve indicated it will most likely not raise interest rates this year.  In perhaps bigger news, it also announced it was scaling back the reduction of its balance sheet.  Over the last few years, the Fed began reducing its balance sheet by not purchasing more bonds as the bonds it held matured.  If the Fed purchases bonds (quantitative easing), it effectively adds cash to the banking system.  If the Fed lets bonds mature and does not replace them (quantitative tightening), it effectively removes cash from the banking system.  In December, the Fed said its balance sheet reduction was on “auto pilot” and it would continue reducing its balance sheet by $50 billion per month until it reached a “normal” level.  In other words, the Fed was engaging in quantitative tightening.  The normal (pre-recession) level is around $1 trillion.  Today, it sits around $4 trillion.  Last week’s announcement indicates the balance sheet is expected to stay around $4 trillion for the foreseeable future; the Fed has effectively ended its quantitative tightening.  The US economy is a tad under $20 trillion dollars.  Think about what an extra $3 trillion in liquidity means to the overall economy.

What does it all mean?  The economy is slowing and the Fed is doing its best to stop the slow down.  What happens when there is excess money in the economy?  Bad risks are taken.  Banks make loans they otherwise would not make.  Businesses buy assets they otherwise would not buy.  Eventually, the cycle ends and the recovery is painful.  We just lived through this with mortgages.  How soon we forget.

If you have time, watch this 30 minute video from hedge fund manager Ray Dalio.  He provides a simple yet thorough explanation of the credit cycle.  I’ve provided this link before.  It is a must watch.  Blame the Fed for the economy’s eventual hangover.

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