Regarding inflation and the Fed, read the following. A little long but an easy read with more questions than answers but food for thought:
The financial story of 2020 to the present day has been the Federal Reserve. They played a crucial role in creating the loose monetary and fiscal policy that drove the fastest economic recovery in history from the pandemic recession.
The same organization has been responsible for the portfolio-destroying tightening of financial conditions over the last year as well. If you had followed the old adage “don’t fight the Fed,” then you would have done well over the first 3 years of this decade.
The Federal Reserve is also at the heart of the most important question in finance today — “when will we return to loose monetary policy?”
Most investors believe that asset prices, regardless of the asset class, will move positive and continue the long-term trend of appreciating against the dollar once the Fed pivots. I think that theory makes sense.
There is a much deeper story around the Fed, interest rates, and inflation though. It is a story of long-term damage that most people haven’t had the time to think about yet. It is really important to start wrapping your head around this though because it will likely drive many of your financial decisions in the coming years and decades.
First, we must acknowledge that the Fed, along with supply chain disruptions, geopolitical conflicts, and human greed, have created immense damage to the American economy and individual’s ability to afford the basic goods such as food, shelter, and gasoline.
To put this in context, Lance Lambert put together this :
Through 35 months, the 2020s decade has seen 15.52% inflation. The entire 2010s decade saw 18.75%.
Simply, we haven’t seen an acceleration of inflation like this in a very long time. The ramifications are hard to fathom. And it is unclear how the next 7 years of the decade will play out.
There is a strong argument that prices for goods and services won’t come back down. We will likely see a slower inflation rate over time, but that only measures the year-over-year change. Use the cost of food as an example. Grocery stores or restaurants are not going to lower their prices when inflation comes down. They can’t do it. There input costs will not let them. So the price changes associated with the recent inflation is here to stay.
How bad have these price increases been? Prices increased in the 12 months ending November 2020 by 1.2%, which was within the target range. But then things got crazy. Prices increased from November 2020 to November 2021 by 6.8%. Prices have risen by 7.1% from November 2021 to November 2022.
This means that the price of consumer goods in the US economy has increased by almost 16% from November 2020 to November 2022 according to the official inflation metrics. And remember, these prices are not coming back down.
That will make it increasingly tough for the average American family to live their life. We know wages are not keeping up with the increased prices of consumer goods. People are falling behind and there is no relief in sight.
Charlie Bilello @charliebilello
US wage growth has failed to keep pace with rising consumer prices for a record 20 consecutive months. This is a decline in prosperity for the American worker & the primary reason why the Fed will hike rates for the 7th time this year at tomorrow's meeting. Charting via @ycharts
4:43 PM ∙ Dec 13, 2022
But this begs a very interesting question — what will the Federal Reserve expect to happen to the inflation rate in the steady state?
We know they continue to target 2% inflation as they have for many years. Before the pandemic era, the Fed would hit the inflation target, or at least be relatively close, using the official CPI metric. It is difficult to see how they will be able to get inflation back down to 2% and keep it there for a prolonged period of time.
The national debt is over $30 trillion and we have no path to paying a substantial amount back. So we are going to have to devalue the currency in order to make the game sustainable. A devaluing currency, especially one in an economy that is seeing larger boom and bust cycles, will only lose value faster and faster as the debt continues to grow.
So maybe the Fed will have to raise their inflation target?
This is not a random idea. I have been
discussing the possibility since April 2022 publicly. On April 19th I wrote:
I have an intuition that the Federal Reserve is preparing to significantly increase the target inflation rate.
This decision will not be taken lightly by the central bank and their leadership, but it ultimately signals that inflation has escaped their control and rather than pull it back in with aggressive monetary policy decisions, the next best option is to simply manipulate the benchmark to make the situation appear less bad.
These things always take longer than we think and it appears that the idea is growing in popularity. Bill Ackman tweeted yesterday that his expectation is for the inflation rate target to be increased to 3% as well.
Bill Ackman @BillAckman
The @federalreserve 2% inflation target is no longer credible. De-globalization, the transition to alternative energy, the need to pay workers more, lower-risk, shorter supply chains are all inflationary. The Fed cannot change its target now, but will likely do so in the future.
9:01 PM ∙ Dec 14, 2022
Bill Ackman @BillAckman
When asked, Powell recommitted to a 2% target, but admitted that examining a higher rate was a possible ‘longer-term project.’ Businesses need price stability, but can thrive in a world with 3% stable inflation.
9:01 PM ∙ Dec 14, 2022
Bill Ackman @BillAckman
I don’t think the @federalreserve can get inflation back to 2% without a deep, job-destroying recession. Even if it gets back to 2%, it won’t remain stable there for the long term. Accepting 3%+/- inflation is a better strategy for a strong economy and job growth over the LT.
9:01 PM ∙ Dec 14, 2022
If the Federal Reserve was to raise their interest rate target to 3%, that would signal a new high(er) inflation environment. Every investor and citizen would have to adjust their assumptions and financial plans to account for this change. It probably sounds super nerdy and non-sexy, but a 50% increase in the inflation target would be a big moment in the American economy.
This brings me back to my point about the long-term damage that has been caused in the last three years. While various people in positions of power and influence were boasting of transitory inflation, we were actually laying the groundwork for a destruction of the economy as we knew it.
Prices are not going to come down. Inflation is still out of hand. The Fed is likely going to have to increase their target rate to appear to find success in the future. The wages of American workers is drastically behind price increases. This whole thing is a complete mess and there is no clear path out of it.
I won’t waste your time pontificating on potential solutions, because I don’t believe there is a tangible solution to dissect unfortunately. Every action that the Fed could take to bring inflation under control, and establish long-term management of the metric, would require a complete destruction of American jobs, businesses, and potentially entire sectors of the economy.
Human-led monetary and fiscal policy, coupled with government-mandated lockdowns that are now having their efficacy questioned, put us in this situation. The pandemic’s impact on the US economy can’t be forgotten. There was a major liquidity crisis in March 2020. Our leaders felt they had to intervene and do something.
It is time we ask though — “would we have been better off doing nothing and allowing the free market to figure it out?”
The answer to that question will be debated forever. But there are more people who say “yes” today than there were last year and I believe that history will be on the side of the free market enthusiasts. Thankfully, for both you and me, I am not in a position of decision-making on these issues though. I simply get to play Monday morning quarterback, so take my perspective with a grain of salt :)
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