Hope springs eternal, as they say, and many in the media are pushing the narrative that inflation has been vanquished – or is at least on its deathbed – and the Fed will not have to raise interest rates anymore. We beg to differ; inflation is still a threat, and the Fed will raise rates more.
The Roots of Inflation Are Still Deep And Strong
As we’ve written before, quoting one of the 20th century’s greatest economists, Milton Friedman, “inflation is always and everywhere a monetary phenomenon in the sense that it can be produced only by a more rapid increase in the quantity of money than in output.”
So, let’s look at that data. The money supply surged by 40% in the two years of the Covid relief effort, which was intended to offset the damage from the Covid-mandated economic shutdown. The effect of the shutdown was to reduce output. This is the textbook example of inflation: the money supply increased more than the output.
Many commentators get this, but somehow there is an assumption, or more likely a wish, that the money supply has been reduced back to its original pre-covid levels and that output has increased enough to match the money supply. This combination simply isn’t true.
The Money Supply Remains Inflated
While the money supply has contracted recently, the decrease was less than 5%. The money supply is still roughly 35% higher than when we started the covid lockdowns. There’s no doubt that economic output has increased. The most recent measure from the U.S. Bureau of Economic Analysis indicates that output has grown roughly 21% over the same period. The conclusion is inescapable: there is still too much money in the system to even hint at a taming of inflation.
What Does The January Data Tell Us
The January data, which is now being released, supports this conclusion. Retail sales rose 3% in January, representing the largest increase in nearly two years. Given the unusually warm winter we’ve had nationally thus far, we should not be surprised to see new homes being built and industrial production picking up as well. All in all, this increased spending is being driven by the extra money still in the system. Since the Fed continues to emphasize its “data-driven” approach, they will most likely see this as evidence that rate hikes must continue.
Has The Fed Got The Right Formula?
There is art and science in this; the science part is the data the Fed has available to look at. They review reams of it and historically can tell us with a relatively high degree of accuracy what happened. The art comes from the fact that the data lags reality by at least a couple of months, if not more. Secondarily, even without the lag, the Fed is still utilizing methods to control inflation. The jury is out on whether this will be successful. We’ve explained this in previous postings, but a quick review is in order.
When the Fed increases the money supply, those extra dollars cause significant inflation, as described above, if they actually make their way into the economy. If the extra dollars stay in banks as reserves, they don’t have an inflationary impact.
In the old system, to tame inflation, the Fed would directly remove money from the banks so they couldn’t come out of reserve and get into the general economy; the banks wouldn’t have the money to lend out. This was called the “scarce reserves” system. Interest rates also rose, but these were in tandem with significant steps to reduce the money supply.
In the new system the Fed is practicing (called the “abundant reserves” system), the Fed relies on interest rates alone to keep the banks from putting the money into circulation. That sounds confusing, but in essence, the Fed pays banks an interest rate on the money they keep in reserves. If the rate goes up, theoretically, the banks find it profitable to keep the money in reserves, earn the interest revenue, and not lend it to the general economy.
Relying solely on interest rates does not remove money from the system. The money is still there. The Fed is counting on the assumption that its new abundant reserves system will be enough. That’s what we have today. The money supply has not been significantly reduced, and the Fed is relying almost solely on interest rate increases to tame inflation.
Can Interest Rate Hikes Kill Inflation Without Killing The Economy?
Interest rate hikes increase the cost of borrowing and raising money. As the costs of financing increase, companies are less likely to invest in new facilities and products, and the consumer is less likely to use credit cards or mortgages. If taken too far, rising interest rates prompt a recession.
The Fed is gambling on the proposition that it can raise rates enough to kill inflation but not kill the economy. The new system is unprecedented, so there’s no history the Fed can study to determine how to do it right, and it’s difficult to predict where that line is; the Fed has to experiment with its interest rate moves. As you might imagine, this new system is almost the perfect environment for a surprise, and markets don’t like surprises.
We don’t believe that the Fed will “kill” the economy in the sense that it may cause a major recession. We have doubts as to whether it can avoid a recession altogether, but we believe any recession will be mild.
From May 2022 through the present time, the stock market has essentially been in a trading zone. A trading zone is simply a range within which the market goes up and down but never really pushes through the boundaries on either the downside or the upside.
In May of 2022, the S&P 500 index was at 4,100; as of this writing, it stands at 4,012. In between, it has seen lows of roughly 3,500 and highs of 4,200; it hasn’t solidly pushed through either of these boundaries.
In terms of broad stock market levels, we believe the Dow and S&P are within fair value ranges. In other words, the market is not irrationally over-valued, nor is it depressingly under-valued. We are likely to see some pressure on corporate profits. The data is contradictory about whether we are already in a mild recession, about to enter one, or will skate by with lackluster profits for a while. The market is forward-looking, but it also has a bit of a cynical view of the economic environment and the Fed’s strategy. We won’t see a major breakout until there is clarity on the success of the Fed’s strategy.
This is not a time for major moves in either direction. An investor’s long-term strategy will still determine their portfolio’s long-term performance, and as long as growth goals are balanced against cash flow needs, everything should work out well in the end.
The current media narrative that inflation has been tamed is simply wishful thinking. Yes, we have seen a downturn in the inflation numbers over the last several months, but too much money is still available to flood the economy and birth new bouts of inflation. The Fed’s approach to this situation is experimental (we’ve never done this before), and the jury is still out; no verdict is close to being rendered on whether the strategy will work. Accordingly, the markets are stuck in a trading range, but investors can continue to prosper long-term. As long as wisdom and patience are the backbones of a portfolio, everything should work out in the end.