đź‘€Inflation Is Inflating Out Of Control. Will The Fed Fight It Or Is The Genie Out Of The Bottle?

I like to think of the economy as a car being driven by the Fed (with Powell behind the wheel). This car can’t drive too fast (high inflation) or else it runs the risk of overheating (we all know how unsustainable that is) but it can’t be driving too slowly either (low inflation) which will mean that growth is pretty sluggish. So the Fed, with its extensive toolkit (interest rates and QE) opts for a nice middle ground. Their role (and sole purpose) is to ensure labour market strength and price stability. To do this, they’ve chosen a somewhat arbitrary number of inflation, at 2%. This has been their benchmark for donkey years.

The problem is that covid swerved this car totally off-course. Causing inflation to run wild. Way above their 2% benchmark. Inflation is typically caused by one (or both) of two things: decreased supply (check!) and high demand (check, check!). Lucky for us, we’ve got both. Entire economies were shut down for months on end (China’s now got Shenzhen under lockdown to curb yet another spread of covid) which caused all this bottleneck supply chain that we’re still experiencing. Months later. Supply had no way of keeping up with demand which meant that the whole system got clogged up. 

Story Time

Then there’s this terribly tight labour market we’ve got going on. Many workers (young and old) decided to quit the workforce. Bring on the Great Resignation. They were either too afraid to go to work what with covid running rampant an all or they no longer wanted to undertake poor work with even poorer pay as is usually the case in hospitality. From restaurants to bars to hotels you name it, have realised they’ve gotta up their pay or else they’ll be left with no workers. So wages slowly crept up. And even more so now thanks to this stupidly high inflation. You were either lucky enough to have your pay automatically rise in line with inflation (sitting at 7.9%) or you demanded one. Or else you’ll leave. And many did just that or at least threatened to! Employers know how hard it is to hire good workers or to hire any workers at all, so they weren’t left with much choice. Workers have the upper hand. Finally! So, as prices rise, wages rise and as wages rise, prices rise. So there ye have it, a nice spiral of ever higher inflation. . 

We’ll Have Some More!

Now that we’ve covered the supply side of things, let’s take a look under the bonnet at all the lovely demand (and very-much-inflation-inducing) stuff. For starters, many of us have been building up a nice pile of savings from not commuting, dining out, shopping, and doing, well, anything! And we wanted to spend it. And boy did we spend it. The pent-up demand is ever so penting that the average American now spends $765 more each month than they pre-covid. Psst: this is without taking inflation into account! Mind you, my gen’s even worse, spending $1,016 a month on average. Guess us young lot just wanna be out living our best life. And that involves a lot of socialising. And as we all know, socialising means spending. But it doesn’t have to be that way since the best things are often free!

But before all that came those good old stimulus packages. Dishing out stimmy checks (and then some!) like candy had to have led to increased demand. Because that’s ultimately what the Fed would have wanted. Why bother to spend trillions of dollars in handing out free (no-strings-attached) money if you didn’t want it to drive demand higher thus driving GDP (economic growth) yet higher. Duh. I dunno why they’re so surprised that inflation is where it’s at. This money just added fuel to the inflation fire. Or is it what started it? 

No Longer Transitory Then, Huh?

Photo by ccd20 on Unsplash

But do you know what? Throughout this inflation migraine, central bankers kept on reassuring us that all these price hikes we’re seeing are transitory. That they’re just the result of lockdowns. That they’ll soon fade. Just like the covid cases. But here we are. Inflation is inching higher with every passing month. It’s now at a 40-year high. And to top it all off, Russia’s gone and decided to launch a full-scale invasion of Ukraine. Oh, and btw Argentina has banned the export of soybean. Think soybean is irrelevant? Guess again! More than 75% of global soy is fed to livestock for meat and dairy production. The rest is used for veg oils along with biofuels and industry stuff. Expect things to get a whole lot worse before they get better.  

Not All Is In Our Hands

The thing is, much as the Fed wishes, it can’t quite control global supply chains. I think this past year has highlighted just how complex, convoluted and completely crazy supply chains are. But what they can do with the tools they have (cough, cough interest rates) is to tame the demand side of things. The Fed can turn down the heat by doing one thing: getting consumers to save rather than spend like no tomorrow. And they can do this by raising interest rates. This will mean that loans (from mortgages to cars) will become way more expensive to service leaving consumers with less buck in their purse. You can though avoid at least some of this by fixing your mortgage for 30 years, pay for your (non-expensive) car in cash or don’t buy one at all so that you don’t have a nasty loan on your head that can quickly rise. One day on the next. 

The thing is though, what many are so freaked out about (especially Powell himself) is the risk of sending the US into a recession. Higher rates slow consumer demand which is ~60 of GDP and if demand turns sour, this could (more like will) drive down economic growth. A recession occurs if there are two consecutive quarters of negative economic growth. A real possibility if rates rise. But surely the Fed’s chief concern and responsibility is to focus on inflation and jobs. That’s their #1 job. Back in the 70s, when inflation was super high, Paul Volcker raised rates to 20%! However, while this certainly helped to drown out inflation (and all the very real pain that brought), it was also responsible for the 1980 and 1981-2 recessions. Something tells me our Fed isn’t gonna let that happen. Or at least they’ll do all they can to stop a nasty recession from coming our way. But perhaps the US economy can handle it? Have we thought about that? One thing’s for sure is that markets already anticipate a rate hike. They’re prepared. Which is good news. 

Photo by Craig Adderley on Pexels.com

But, if the Fed does nothing (or hikes rates by a measly 0.25 basis points), they risk stoking inflation yet higher, denting consumer confidence and shrivelling what little purchasing power our monies still have. Though, all this inflation that lingers around is doing one good thing. It’s wiping out some of the value of the Fed’s whopper debt pile. That gained some (trillions) of lbs. More like dollars. If, on the other hand, the Fed raises rates, while they cool off inflation the repayment on their mountain of debt will keep on inflating like a balloon. Take inflation away (or at least part of it) and we’re left with a big (not smaller) pile of debt that will become someone else’s problem.

Whichever way you look at it, the Fed’s got some tough choices ahead of them. I, for one, do not envy them one bit. I will gladly watch (and write!) from the sidelines.

Anyway, keep those purse strings tight. Better be safe than sorry.  

Disclaimer: This blog is not investment or financial advice. It is my opinion only. This blog is not a personal recommendation to buy/sell any security, or to adopt any such investment strategy. Always do your own research before you commit to any investment