Inflation is Enemy #1
As we’ve covered in recent blog posts, the past decade was one of unprecedented stimulus. The Federal Reserve Bank of the United States (the “Fed”), and other central banks, were arguably over-accommodative, through interest rate policy and an unprecedented increase in M2 money supply. This massive stimulus contributed to the current inflationary environment, and now the Fed is doing its best to rein-in inflation via interest rate increases and “quantitative tapering” (i.e., a discontinuation of its bond buying program). The ongoing direction of inflation will continue to impact Fed actions, which, in turn, will impact markets. So, let’s explore where we’ve been and where we may be heading.
On the inflation front, the Fed is either not being forthcoming or, more likely, poorly modeling the impact of their actions. We were first told that inflation was not a concern, then told that inflation was transitory, and finally this gem - “We now understand how little we understand about inflation” (Jerome Powell, Federal Reserve Chairman, June 29, 2022). The continual pivots in rhetoric from the Fed do not inspire confidence. The Fed has two “mandates” which are (1) full employment and (2) stable prices. Oddly, the Fed has defined “stable prices” as steadily increasing prices at a rate of 2% per year. In this regard, they are way off target. Below is a chart of year over year inflation as measured by the Consumer Price Index (“CPI”) which represents a basket of consumer goods. Recent year over year changes have surpassed 9% which are levels not seen in the United States since the 1970s.
Inflation is widely considered to be detrimental for both individuals and economies. Individuals see their hard-earned dollars lose purchasing power and are thus forced to make consumption changes. Generally, discretionary spending (i.e., spending on non-critical goods) tapers during these periods with significant adverse economic impacts. In fact, historical analysis shows that rising energy and commodity prices can lead to recessions. Moreover, lower income individuals, along with retirees who are living on a fixed income, bear the brunt of price spikes as their incomes generally do not keep pace with inflation. As such, periods of rising inflation are often accompanied by significant civil unrest – a scary proposition for world leaders.
Given the inflation issues, the Fed, and other central banks are taking aggressive steps to stop it. For one, the Fed has been busy raising interest rates throughout 2022. After spending much of the last decade with a near-zero interest rate policy, they have increased the Federal Funds Rate 2.25%, in aggregate, since the beginning of the year (25bp in March, 50bp in May, 75bp in June and 75bp in July). Moreover, comments following the most recent increase on July 27th suggest that they will continue until inflation begins to move materially back toward target. At the same time, the 10-year treasury has fallen from 3.4% to under 2.8%. This suggests the market believes the Fed may slow down its pace of rate hikes, or perhaps, cut them as early as next year. Unless there is a swift, meaningful reduction in inflation, this doesn’t make much economic sense.
Many economists suggest that a recession is the only possible outcome from such aggressive rate hikes. In fact, history shows that recessions often follow central bank tightening. Recessions, however, have historically led to rising unemployment. So, the Fed’s dual mandates of “full employment” and stable prices may be in competition with each other. Based on Fed rhetoric, inflation is the primary concern at present, and it appears that the Fed is quite willing to cause “demand destruction” (i.e., reduced consumer spending and adverse economic impacts) to lower inflation. Based on the Fed’s public statements, it appears that rising unemployment is deemed the lesser of two evils.
So, the million-dollar question for portfolios is – “Where do we go from here?” Continued rate increases would prove detrimental for stock and bond prices in the short-term. However, any reversal of course (i.e., a pause in rate increases or rhetoric that suggests future changes will be below what the market now expects) would provide a tailwind as we saw in the few days following the Fed’s July announcement. It’s a tricky time for investors.
Our belief is that the Fed probably doesn’t have the ability to raise rates much higher than they are now. Businesses, along with the Federal Government itself, are highly indebted. So, by raising rates, the Fed is going to do damage to corporate profit margins and cause unemployment while potentially increasing the borrowing cost for itself. Below is the level of U.S. debt as a percentage of GDP. It’s been a long time since the U.S. government’s balance sheet looked this bad.
We have previously commented that the best way out of this predicament of a high debt-to-GDP ratio is probably the post-World War II playbook (i.e., let inflation run a little high until debt is reduced as a percentage of GDP) – See “Are We Headed for Yield Curve Control?”. In fact, governments haven’t historically paid off debt – rather, they generally either default or devalue currency until debt moves back to tolerable levels. So, despite the tough rhetoric about inflation, we would guess that the Fed would be comfortable seeing inflation higher than 2% for a while (e.g., 3-5% is our guess for the real near-term target level) and we may hit that pace before the end of 2022. As always, we will keep a close watch on the unfolding situation and will look for opportunities to capitalize.