March 21: Not exactly surprising that the Fed’s dot plots indicate 3 rate cuts this year. The now dovish sounding Fed has no choice but to cut rates. It claims it also wants to slow its balance sheet run off which is a more complicated process than what it might seem. Nevertheless, slowing its balance sheet run-off remains consistent with cutting interest rates.

Let’s examine the balance sheet run-off aspect by looking at the opposite scenario first. When the Fed buys bonds and builds up its balance sheet it injects money into the economy and expands excess reserves in the banking sector. This makes credit easier to get and lowers the Federal Funds rate, which is the private sector overnight rate that banks lend excess reserves to one another in order to meet their reserve requirements. The Fed announces this expansionary process buy cutting interest rates, or equivalently, the discount rate that the Fed sets for making loans to banks to meet their reserve requirements. Typically, the Fed seeks a private market Federal Funds target rate that is a little less than the directly set discount rate. This is so that Federal Reserve system banks will tend to borrow excess reserves in Federal Funds market rather than at the Fed’s discount rate. This allows the Fed to scrutinize banks that borrow from it at a higher rate than they could in the Federal Funds market, possibly indicating a bank that is in a bit of trouble.

When, in contrast, the Fed raises rates it typically sells bonds thereby reducing excess reserves in the banking sector, raising the Federal Funds rate, and reducing the money supply in the economy in order to fight inflation. This process makes credit harder to get and slows aggregate demand. Although the Fed has ended its campaign of raising rates it has never simultaneously embarked on a bond selling scheme. Instead it has simply allowed its balance sheet bonds to mature and then roll off its balance sheet. In other words, it has slowly allowed its balance sheet credit to decrease. This has reduced the money supply (such as the monetary aggregate M2) very little.

As I have indicated, the rate these bonds mature and role off the Feds balance sheet are beginning to accelerate, and quite rapidly. When the US Treasury refinances this government debt at higher rates and auctions the bonds the money supply is decreased. The rate of money supply decrease will accelerate with the rate bonds mature and role off the Feds balance sheet. The Fed has no control over this process and thus cannot directly reduce the rate of its balance sheet run off in spite of its intention to do so.

So, what can the Fed actually do? Maturing bonds represent government debt that must be refinanced by newly issued Treasury bonds. Since the Fed cannot slow is balance sheet run off directly, the only thing it can do to slow its balance sheet run off is to buy up some of the newly issued and higher rate bonds. It must do this fairly soon. Otherwise, banks will use their excess reserves to make loans or create assets by purchasing these zero risk, higher rate bonds from the Treasury. This will decrease excess reserves and drive up the Federal Funds rate so as to become greater than the Feds discount rate. Assuming the Fed doesn’t want this to happen it must buy up some of the bonds before the banks do and thereby monetize the newly issued higher interest rate government debt. This is what the Fed actually means when it says it wants to slow its balance sheet run off. Of course, when the Fed buys bonds it must correspondingly cut its discount. rate in order make everyone aware of just what it is doing.

When the Fed monetizes US government debt it is expansionary, especially on the aggregate demand side of the economy. Thus, instead of trying slow the economy with interest rate hikes, it must now stimulate the economy with interest rate decreases and money supply increases. Luckily, we also have secular productivity increases on the supply-side of the economy caused by AI. The productivity increases due to AI decease the unit cost of output, increases business profits, and increases real incomes. The labor market will stay relatively tight as long as the technological advances are more labor augmenting than they are labor substituting. Like during the 90s when microcomputers were introduced into production processes, AI appears to be relatively more labor augmenting, at least on average.

During the mid 1990s the Clinton Tax increases, military expenditure decreases, and Republican social funding decreases combined to be very contractionary on the aggregate demand side of the economy. That said, supply-side forces such as the increased use of microcomputers and low oil and gas prices dominated the contractionary forces on the demand side of the economy and created an economic and stock market boom during the 90s. I expect similar supply-side expansion to occur again but this time driven by the increasing use of AI. The big difference with the 90s is that there are no fiscal austerity or contractionary forces on the demand side of the economy, but instead only expansionary forces. However, if aggregate supply growth dominates aggregate demand growth, inflation and potential asset bubbles associated with excessive money supply growth such as occurred from 2001 through 2007-8 might become less of a problem.

So, with good times expected, I’d consider growth stocks such as: ACMR, AMSF, EIG, WMS, AWI, CRH, IBP, KNF, LRN, MGDDY, and IMXI. For dividends and growth, consider: BCSF, KRO, LXFR, and OUT. Over the preceding 3 months, the fastest growing ETFs were: SMH, SOXX, SOXQ, IGPT, and IGM. As always, good investing!