Editors’ Note: As far back as last summer, The Prickly Pear began to warn about 2022 being a “risk-off” year.  Those elements of the economy, including stocks, bonds, cryptocurrencies, and real estate that have been elevated by easy money, will tend to suffer when the easy money is taken away. We are now well into the process as the author explains. However, market action will be uneven, and markets rarely decline without lots of zig-zag interruptions. Recent data suggest the market are for the moment getting very oversold, pessimism is running deep, and under those conditions, a contra trend rally or bounce can be expected. If we are correct that such a rally will ensue fairly soon, this may be the last opportunity for investors to sell into strength to make whatever asset allocations adjustments they and their advisor may feel necessary for their particular circumstances. However, in the somewhat longer term, all markets will have to adjust to a higher interest rate environment, less monetary stimulation, and likely a slowing economy.

An aircraft pilot about to crash will repeat the distress signal “Mayday.” Throughout the “May days” of this month so far, financial markets have been sending distress signals that may indicate an imminent crash of their own. The major stock market indices have all been experiencing steep sell-offs since May 4, extending a decline that began around the end of March.

Most analysts attribute the sell-off to inflation fears. Traders aren’t worried about how inflation will directly affect the economy, but how it will influence the decisions of a handful of bureaucrats. They fear that it will lead Federal Reserve officials to tighten the money spigot that is driving the inflation in the first place.

The Fed’s money pumping has driven up prices across the board, but especially the prices of capital goods (the value of which is derived from the value of the future consumption goods they will yield) relative to present consumption goods. That ratio, as Austrian economists explain, is the basis for interest rates. By distorting it with its money pumping, the Fed has artificially lowered interest rates so as to “stimulate” the economy.

This has been the Fed’s standard operating procedure since its founding in 1913, but it has precipitously ramped it up since the advent of Covid in order to prop up an economy staggering under the burden of draconian governmental responses to the disease.

If, as traders fear, the resulting inflation prompts the Fed to ease up on the money pumping, that will allow interest rates to rise by pulling out the props holding up capital prices at artificially high levels relative to present consumption goods. This upheaval in relative prices will translate into severe losses for most businesses, revealing that, lured by the Fed’s artificial stimulus, they had overextended themselves.

This general spike in market losses is what’s known as a “crash” and “recession.”

The bust we need will be extremely painful because the Fed has been money-pumping at ever-increasing unprecedented levels and without stint since the financial crisis of 2008. But kicking the can down the road even further will only mean an even more painful bust when the Fed finally does relent.

And that’s if we’re lucky. If the Fed never relents, its policy will eventually result in hyperinflation, which can be a civilization-killer.

The market is crying out Mayday. Let it crash. And then let it rebuild and re-ascend sustainably under its own power.

The government got us into this mess, but only the market can get us out. And, as the poets say, the only way out is through.

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This article was published by FEE, Foundation for Economic Education and is reprinted with permission.