1. Will the Fed act to head off U.S. inflation before it appears by raising U.S. interest rates soon?
2. Will the Fed act as if the U.S. Dollar is the world reserve currency? If they take this view, they must move slowly to raise interest rates, because the world today is plagued by deflationary influences, and the world economy is growing very slowly. In this case, the Fed will not raise interest rates soon.
The Historical Parallels
- Debt hit a bubble top in 1929 and in 2007.
- Stock and some bond markets crashed, some financial institutions failed (many more in the 1920s and 1930s than has been the case since 2007).
- Money printing began 1933 and 2009. No more debt growth was possible, so money printing took place to reverse the downturn.
- Stock markets around the world rallied, 1933 to 1937 and 2009 to 2014.
- The economy improved, 1933 to 1936 and 2009 to 2014.
- In 1937, the Fed tightened reserves, and as a result, the U.S. stock market fell after the second tightening occurred in March 1937 and the third in May 1937. The market began to fall in March 1937, and fell until March 1938 — declining more than 50 percent.
- There was a tax component to the problems in 1937 as well — the Social Security tax was inaugurated, and there was a smaller cut in government spending. The combination of higher interest rates, higher taxes, and slightly less government spending was toxic for stocks and the economy. 2013 saw an increase in U.S. income tax rates, and 2014 saw the approval of the Affordable Care Act, which has 21 different taxes imbedded in it. Spending is falling as a percentage of GDP, but it is rising in absolute terms. So there are two similarities and one difference between 1937 and today.
We are confident that the Federal Reserve would not like to see a significant decline in the stock market accompany their interest rate increases. The Fed did not expect interest rates to rise and stocks to fall so hard when they took action in late 1936 and early 1937.
We wrote the above analysis in the lead-up to yesterday’s statement from the Fed’s Open Market Committee (FOMC). In her press conference yesterday afternoon, Fed Chair Janet Yellen gave us a reason for optimism when she assured us that even if inflation were to return toward 2 percent, and employment were to continue to make gains, the Fed was unlikely to press for higher rates until the economy was stronger and inflation appeared to be on the verge of becoming problematic. We view her remarks as bullish for stocks in the U.S., Europe, India, and China — in great part because we expect no Fed rate increases until the beginning of 2016. We had been of the opinion that they could rise in September 2015.
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