The past decade was one of unprecedented monetary stimulus. The Federal Reserve Bank of the United States (the “Fed”), and other central banks, were arguably over-accommodative. 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). Ongoing inflation will continue to impact Fed actions, which, in turn, will impact markets.
On the inflation front, the Fed is either not being forthcoming or, more likely, poorly modelling 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 from Federal Reserve Chairman Jerome Powell on June 29: “We now understand how little we understand about inflation.” 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. On the “stable prices” front they’ve defined that, oddly, to mean steadily increasing prices at a rate of 2% per year. On this front, 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%, a level not seen in the United States since the 1970s.
Inflation is generally horrible for individuals and economies. Individuals see their hard-earned dollars not purchasing as much as they did before and are 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, are hurt the most by 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.
The Fed and other central banks are taking aggressive steps to stop inflation. 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 (25 basis points in March, 50bp in May, 75bp in June and 75bp in July). Moreover, comments following the most recent increase July 27 suggest that they will continue until inflation begins to move materially back toward target.
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 have historically led to rising unemployment. So, the Fed’s dual mandates of “full employment” and stable prices may be competing with each other. Based on Fed rhetoric, inflation is the primary concern at present. 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, rising unemployment is deemed the lesser of two evils.
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. 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.
The best way out of this predicament of a high debt-to-GDP ratio is probably the post-World War II playbook: let inflation run a little high until debt is reduced as a percentage of GDP. 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 (3-5% is our guess for the real near-term target level) and we may hit that pace before the end of the year.