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As widely expected, the Fed raised its target rate today, its first rate hike since December 2018. As you may recall, that hike crashed the stock market in what became known as the Christmas Eve Massacre.

Today's hike was only 25 basis points, not the 50-point hike some were predicting prior to the Russian invasion of Ukraine. In a sense, Putin took the pressure off Jay Powell to make a bolder move.

The market rallied today, closing up big, but that's not really a surprise. Markets were expecting a 25-basis-point hike, and they got one. What the stock market doesn't like is surprises.

But what happens to the market going forward could well be a different story.

Although today's hike was minor, up is up. Importantly, this rate hike is the first of many more to come. We don't have to guess at that. The Fed has already told us that's their intention.

The Fed also confirmed today that the taper is over. A so-called taper is the process of slowing the rate at which the money supply is expanding.

How Is Money Printing Tightening?

When the Fed buys Treasury securities from banks, they pay for the securities with money printed from thin air. That's called quantitative easing, or QE. The Fed has been doing that since early 2020 when the pandemic began.

The Fed gets out of QE in stages by reducing the amount of securities they buy each month; that's the so-called taper. They're still printing money, but the amount printed is reduced until it hits zero.

It may seem odd to call money printing tightening, but everything in markets happens at the margins. If the Fed is printing less, they are tightening even though they're still printing. The amount of QE hit zero last week, so QE is now officially over, the taper is done and the Fed is contemplating their next move.

The Fed also signaled they intend to actually reduce the money supply in the near future. This is the opposite of QE and is called quantitative tightening, or QT. This has not yet begun, but the Fed has made it clear they will start QT soon.

A Triple Whammy

So we have three forms of tightening at once: the end of QE, a rate hike and the beginning of QT. This is a triple whammy that will slam the U.S. economy and send stock markets down sharply in the days ahead.

That's not what the Fed wants, but that's what they're going to get.

When the Fed started QT in late 2017, they urged market participants to ignore it. They said the QT plan was on autopilot, the Fed was not going to use it as an instrument of policy and that it would ?run on background? just like a computer program that's open but not in use at the moment.

It's fine for the Fed to say that, but markets had another view. Analysts estimate that QT is the equivalent of two?four rate hikes per year over and above the explicit rate hikes.

Not surprisingly, we had the Christmas Eve Massacre in December 2018, and Powell was forced to begin easing policy again.

The key takeaway is that tightening policy in a weak economy is almost certainly a recipe for a recession.

When the recession does arrive, the Fed won't have enough ?dry powder? to fight it. The Fed needs rates to be at least 3%, and preferably higher, when recession begins. That gives it plenty of room to cut rates.

But recession will hit long before the Fed can get rates that high, so cutting rates won't be much help.

The Fed Is Far Behind the Curve on Inflation

Today's actions are all in response to raging inflation. But it's too late. The Fed is far behind the curve. The inflation is here and it's about to get worse. Even worse, the Fed doesn't understand why.

They're used to models that focus on ?demand pull? inflation where consumers are buying in anticipation of even higher inflation to come. But the data shows that consumers actually don't expect much inflation after this initial wave.

Medium-term expectations are still anchored. The best research shows that expectations are overrated anyway. What affects behavior is what's happening right now, not the expected future.

The inflation we're seeing is called ?cost push? inflation. This comes from the supply side, not the demand side. It consists of higher oil prices due to Biden policies of shutting down domestic oil production. It also comes from global supply chain disruption, and now the war in Ukraine.

Since the Fed has misdiagnosed the disease, they are applying the wrong medicine. Tight money won't solve a supply shock. Higher prices will continue. But tight money will hurt consumers, increase savings and raise mortgage interest rates, which hurts housing.

The Fed is tightening into weakness.

The Fed's Nothing if Not Consistent

The Fed's track record of using the wrong models, using flawed models and doing the wrong thing at the wrong time remains intact. Today's Fed announcement is the beginning of a chain of tightening that will sink stock markets and slow the economy.

Those rate hikes are a huge mistake, but the Fed will do it anyway. It really has no clue about the real world. I'm a big critic of the Fed models because they're obsolete and they don't accord with reality. When the Fed realizes its mistake of tightening into economic weakness, it will have to turn on a dime and shift to an easing policy.

What would cause the Fed to back off? A market meltdown. If the stock market sells off 5%, which would be over 1,700 points on the Dow, that would not be enough to throw them off. But if it goes down 15%, or over 5,000 points from current levels, that's a different story. Ben Bernanke actually told me that once.

Easing will come first through forward guidance and pauses in the rate hike tempo, then possibly actual rate cuts back to zero and finally reversing their balance sheet reductions by expanding the balance sheet through more QE if needed.

But by then, the damage will have been done. We can see the damage coming and plan accordingly.

Regards,

Jim Rickards
for The Daily Reckoning

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