The inflation news is confusing, and we want to take this opportunity to help clarify why. We’ll start with the fact that the Fed is practicing a unique method to try and control inflation (more on that later). Add to this that there have always been lags between the various indexes which measure inflation, and you have the perfect recipe for competing news reports and even Fed announcements.
While not an exhaustive list, the various quoted indexes include the producer price index and the consumer price index (CPI). Within the CPI, we hear about the energy price index, food price index, and core price index. There are plenty of times when these do not move in the same direction, and even when they do, they move at different times and at different rates.
This scenario is the perfect recipe for confusion, and unfortunately, it allows some commentators to latch on to a particular index that supports an opinion they already hold. The truth can be hard to find, and the market needs the clarity of truth. We saw this confusion play out in a 1,000+ point drop in the Dow on September 13th. Earlier reports that some indexes had actually decreased gave hope to the wish that inflation had been tamed. Unfortunately, this month’s true inflation data showed that inflation was still strong.
The Fed Enters Uncharted Territory
Where the market had expectations that the Fed would be able to temper interest rate hikes, it now realizes that several more significant hikes are needed to conquer inflation. One of the key questions is whether these rate hikes and/or other actions will have to go so far that they cause a recession. This outcome is not a forgone conclusion, but it is a possibility. All eyes are on the Fed right now.
As we mentioned above, the Fed is practicing a unique method to control inflation, and the jury is out whether this will be successful. To better understand the situation, we need to review a basic principle: inflation is, and has always been, created by too much money being put into the economy. This is simple to say but not so simple to predict.
When the Fed increases the money supply, as it did in 2020 (24% increase) and in 2021 (12% increase), those extra dollars can cause significant inflation. It depends on whether the money actually makes its way into the economy or stays in banks in the form of reserves. There is often a lag effect here; extra money is put into circulation, but it takes six months before it actually gets out into consumers’ hands and starts to impact prices.
In the old system the Fed used, it would directly remove money from the banks. The banks wouldn’t have the money to lend out. In the new system (called the “abundant reserves” system) the Fed is practicing, 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 and earn the interest revenue.
Relying solely on interest rates does not remove money from the system. The money is still there. In the model the Fed uses, the money would stay in the banks, and inflation would be tamed. We are witnessing a great experiment as to whether this new method will work.
Are Interest Rate Hikes Enough to Tame Inflation?
The Fed believes it can manage inflation and economic growth simply by targeting short-term interest rates. As long as they maintain this belief, they will continue to raise interest rates, believing that there is an interest rate level that works perfectly. We, therefore, expect interest rates to rise another 1% to 1.5% over the next six months or so.
If this works, then we would expect that we can avoid a major recession. Growth will certainly be diminished – we may even experience a small technical recession – but we don’t believe a major recession is inevitable.
The Stock Market is Fairly Valued
In terms of broad stock market levels, the Dow and S&P are within fair value ranges. That doesn’t mean there won’t be major swings up or down, just that we don’t believe there is a long-term pull in either direction right now. This will be determined by how far the Fed feels it has to go.
Practically speaking, there are still great companies here in the US and throughout the world providing high-quality products and services at profitable levels. Those stocks are worth owning and keeping. Interest hikes will impact bond levels, and current bond portfolios should be positioned on the short-term side of the spectrum. As various companies and government agencies issue new bonds, their interest rates will reflect and pay the new bond owners the higher rates dictated by the Fed’s actions. In short, not all bonds are bad. It will be more important to know which bonds to own to ride out this inflation battle while providing the needed allocation balance to stocks in a portfolio.
Balancing Tactic and Strategic Issues
This is not a time to abandon stocks or bonds; this is not a time to practice market timing despite its potential heightened emotional appeal. Here at First Financial, even we have experienced a dramatic increase in the number of solicitations promising to protect portfolios against this calamity or that calamity. There are always sharks in the water, but times like now are when they start circling the boats of gullible investors.
The strategy now is to stay true to long-term targets and be tactically prudent in picking the right stocks and bonds to own while ensuring that short-term liquidity needs are held securely.
Inflation news is confusing, and competing voices – many with ulterior motives – make competing predictions. Normal uncertainty and difficulty in discerning the truth is compounded by the Fed’s current unique method of trying to control inflation. Markets are trying to figure out what the Fed is going to do and, more importantly, whether it will be successful. Whether we avoid a recession, or simply experience a mild technical recession, will be determined by whether the Fed’s new method is ultimately successful. The implications for investment portfolios will impact both strategic and tactical considerations.