As Economic Cycles Coincide, Fed Faces Risky Balancing Act

For most of 1991, the cyclical and seasonal factors have been positive for the financial markets. The economy has been weak, there has been no need to build retail inventories, and the has Fed actively driven short-term rates lower. The securities markets have reached new highs.

At present, the cyclical and seasonal factors are both beginning to tighten. The economy is showing signs of a weak revival and inventory building is about to begin in the retail sector.

Willingness to Ease

This would normally put pressure on the financial markets. But the Fed, worried that M2 is growing at an inadequate rate, is apparently signaling a willingness to provide enough liquidity to the system to drive short-term rates even lower (as evidenced by last Friday's cut in the discount rate).

The extra short-term liquidity would prevent problems in the financial markets and a return to recession in the 1992 election year.

The risk, of course, is that fear of inflation in the long-term bond markets could exert enough pressure to force the Fed to reverse.

Longer-Term Rates

There is definable interplay between rates in the securities markets themselves. If the lender/investor decides that inflation is likely to reignite, or if the dollar declines sharply in value because of excessive Fed monetary ease, long-term interest rates will not decline.

Money will flow to the sector where relatively high real returns are expected -- that is, it will flow out of the short-term markets and into the long-term markets.

Fed Power Has Its Limits

The Fed cannot prevent this from happening. If it attempts to sharply increase money-supply growth, it will exacerbate fears concerning inflation and accelerate the move to the long-term market.

Thus, the desire for money to seek the highest return affects the relationship between the long-term and short-term money markets.

Of greater interest is the interplay between the long-term bond market and the stock market in isolating the factors that effect bank stocks. This will be discussed in an upcoming Comment.

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