My logic for tightening now is different — in my view the Fed is targeting the wrong inflation rate. The real damage done by inflation is that it undermines capital formation by forcing people to hold the wrong assets. Investors’ most important decision is how to divide their portfolios between tangible assets like real estate and financial assets like stocks and bonds. It is the inflation rate of tangible assets, not inflation measured by the consumer price index (CPI), personal consumption expenditures (PCE) or any other basket of consumer goods that matters for interest rates and capital formation because rising real asset inflation induces people to shift portfolios away from financial assets. This pushes stock and bond prices down, raises interest rates and the cost of capital for new investments, and undermines capital spending and long-term growth.
Looked at this way, inflation is already well over the Fed’s 2-percent target. According to the latest existing-home-sales report, the median price of an existing home increased 5.6 percent over the past year. A person buying property with a 20 percent down payment and a 4 percent mortgage rate would earn a 12 percent annual return on their equity, significantly higher than the 6 percent to 8 percent expected return on stocks or the 2 percent return on Treasurys. Put another way, the real interest rate that matters — the difference between the rate of return of a real asset and the financial asset you would have to sell in order to acquire it is negative.
Shrinking the Fed’s balance sheet is not going to be as painless as some say. It matters not a whit whether the Fed shrinks its balance sheet by selling a bond or by collecting the principal of a bond that is maturing. Either way, the person on the other side of the transaction writes a check to the Federal Reserve, which reduces the stock of bank reserves by exactly the same amount. “Not reinvesting” is no less painful that outright selling. And the pain could be substantial. At the $50 billion per month maximum the Fed announced today, the Fed would have to sell bonds every month for 3-5 years.
How today’s “data-driven” Fed reacts to that pain is the silver dollar question. My guess is their tolerance for slower growth, rising unemployment, rising interest rates and falling stock prices will be limited. For that reason, my investment strategy will be to bet against the Fed’s anti-QE program by increasing exposure to commercial real estate and commodities, by opting for long-term fixed rate financing, and by keeping fixed-income maturities very short.
Commentary by John Rutledge, the chief investment officer at Sanafad, a global principal investment house. He is also a senior research fellow at Claremont Graduate University, where he teaches complexity economis and finance. Follow him on Twitter @johnrutledge.
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