July 25, 2022

I bet you can guess what one of the worst-case scenarios for the stock market, one that would make for deep losses. In fact, it’s happening right now. It’s rampant inflation.

Inflation was cooking at an 8.6% annual rate in May, according to government figures, and it’s dooming stocks. That’s because the outlook for equities is heavily dependent on the Federal Reserve.

See, after decades of increasing monetary intervention, the markets and economy have become dependent on the Fed’s easy money policies. Cheap money? Yes, please. Eventually, the borrowers keep coming back because they need the cash to function.

Whenever the Fed has tried to tighten up, big problems followed. It’s played out that way for two decades, and really became apparent after the 2008-09 financial crisis. This can’t continue over the long run.

Since the Fed can’t return to the “easy money” days, there are two potential outcomes ahead for us, based on past inflation. Unfortunately, neither is appealing.

The first scenario is what we’ve seen in the past – inflation would be transitory and begin to moderate, then interest rates would likely follow as the economy cooled off. In this scenario, stocks would likely still struggle, the economy would be weakened, and recession would probably hang around until the Fed resumed easing.

The second scenario is more worrisome. In this case, inflation would grind higher, bringing interest rates along. The Fed would likely feel forced to continue tightening, even as the economy began to significantly slow and markets buckled. Eventually, rising inflation and rates would force the Fed to act differently, and that would probably bring big downturns in the economy and markets.

It’s incredible how things have changed. We went from “don’t fight the Fed” to now the Fed is screwing everything up.