Likelihood of Fed over-steering increases

In the past, we've compared the Fed's extreme interest-rate swings to a driver of a car going out of control, and we believe the image is a helpful one.

Like an inexperienced driver going too fast on a road with little traction, the Fed's overzealous turns on the steering wheel can lead to a damaging wipeout, especially when one overcorrection is followed by another even larger overcorrection in the opposite direction.

We have argued that the promising technological innovation of the late 1990s was not an illusion but that the real companies creating progress during that time period were caught up alongside companies that were nothing but hype. When the Fed's easy-money policy leading up to the year 2000 created a bubble, the Fed over-corrected for that easy policy with a rapid round of tightening, culminating in a round of deflation. This unfortunate turn of events wiped out many telecom/technology-related companies that had financed their investment plans using debt.

After the disastrous impact of that tightening became evident, the Fed became overly-easy again, leading to a real estate bubble, which further diverted capital from tech investment and led to the cataclysm of 2008-2009.

Technology has been getting back on track again following that almost ten years on "pause," with potentially huge improvements being applied to virtually every aspect of life and business. We have called this phenomenon the "Unstoppable Wave" and have written about it extensively -- even arguing that it is such a powerful paradigm shift that government ineptitude would have a hard time derailing it.

However, one concern we have is that the Fed could blunder in almost the same way they did ten years ago by keeping their foot on the accelerator for too long. This danger is evident in that they have held the Fed funds rate at zero for over two years now. This could mean they have put themselves in a predicament that would force them to spin the wheel wildly to the tighter side when the wall of rising inflation suddenly looms into view.

We believe the likelihood of another oversteering scenario is depressingly possible, with the Fed and many pundits thinking that inflation is unlikely as long as unemployment remains high (a view we think is suspect, at best, and can be traced to the influence of the Phillips Curve). Unfortunately, to use another automobile metaphor, inflationary pressures often act like an overheating engine radiator: pressures build up under the surface and suddenly blow without warning.

One difference between today and 1999 is the fact that many of the leading companies today (especially tech companies) generally have tons of cash and low or no debt. While the continued possibility of Fed oversteering is unfortunate, and may make growth and progress slower than they otherwise could be, we are not bailing out on the "Unstoppable Wave" thesis. We are simply pointing out the likelihood of future Fed over-tightening to make up for the over-easy policy of the past two years, and recommend investors be cautiously optimistic as they allocate dollars in their portfolio.

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For later posts dealing with this same subject, see also: