As stock market plunges, a star money manager says the Fed is making a mistake by focusing on rates. Here’s what Scott Minerd says it should do instead.

“For all the hoopla about the Federal Reserve (Fed) raising short term rates, policy makers may be missing the best opportunity since the Great Financial Crisis to ‘normalize’ monetary policy,” writes Minerd, in a client report shared with MarketWatch ahead of its wider distribution.

Market-based projections imply that the FOMC will lift federal funds rates, which currently stand at a range between 0% and 0.25%, at least three times in 2022 and other economists and market participants are predicting and even more aggressive plan of rate increases by the Fed as it tries to douse a surge in inflation that have been at least partly born of supply-chain bottlenecks, labor shortages and a pickup in demand as consumers try to emerge from COVID-induced lockdowns.

Minerd, however, makes the case that the Fed should be fixated almost exclusively on a reduction in its balance sheet, which currently stands at around $8.7 trillion.

See: The Federal Reserve’s first meeting of 2022 looms as risk of inflation outside of policy makers’ control builds

The CIO says that reducing the overall balance sheet, which has contributed to inflated values in everything from stocks to cryptocurrencies such as bitcoin
BTCUSD,
-2.81%,
could be managed better by pulling back on the supply of liquidity, which the market has enjoyed.

“Changes in money supply are a powerful driver of economic output, asset prices, and inflation,” writes Minerd.

“Interest rates are the byproduct of monetary liquidity, economic output, and inflation expectations. Short term market rates can be manipulated through changes in the stock of money,” he wrote.

Minerd says that one of the negative ramifications for the size of the Fed’s balance sheet was the reverse repo rate, a key artery of global financial markets.

The Fed’s reverse repo program lets eligible firms, like banks and money-market mutual-funds, park large amounts of cash overnight at the Fed, at a time when short-term funding rates have fallen to next to nothing, and where finding a home for cash has become harder.

The program had almost no participants in early April of last year, and few since the pandemic’s onset in the spring of 2020, but demand surged in May 2021.

“That facility now has daily volume of over $1.5 trillion,” writes Minerd. “Any program to raise rates will require the Fed to raise the rate of interest paid on RRP operations by the amount of the increase in the overnight target rate,” he said.

“In essence, the Fed will establish an artificial rate which is not set by market forces,” Minerd said.

In other words, the free-flowing liquidity has created artificial levels for rates that aren’t driven by market forces.

Minerd says that without the ability to accurately discern the state of the market through mechanisms like the RRP, the Fed is essentially flying blind.

“Without market forces, the Fed will have no ability to recognize what the true demand for money would be if interest rates could freely float and thereby create a signaling mechanism to indicate the true equilibrium rate of interest,” he writes.

Minerd said that raising rates dramatically would destabilize the financial system and railed against suggestions that the Fed should focus on “shock and awe” tactics by delivering a hike of 50 basis points, rather than the 25 basis points that markets are pricing in.

Economists are, in fact, expecting the Fed to reduce its asset purchase program, ending that program as early as March, lifting interest rates as many as three times and winding down its balance sheet.

Read: Is the market crashing? No. Here’s what’s happening to stocks, bonds as the Fed aims to end the days of easy money, analysts say

Minerd would encourage the Fed to focus on its balance sheet. He says that controlling the growth of money supply may be more influential in resetting policy and a better tactic for the central bank than interest rate increases.

Minerd’s comments come as the S&P 500 index
SPX,
+0.28%,
the Dow Jones Industrial Average
DJIA,
+0.29%
and the Nasdaq Composite Index
COMP,
+0.63%
were tumbling to fresh lows amid a withering start to the year for Wall Street investors. Meanwhile, the 10-year Treasury note yield
TMUBMUSD10Y,
1.759%
was at around 1.72%, pulling back from its recent highs around 1.9% but still up significantly from the end of 2021.