Don’t Count on the Fed to Tame Inflation
Fool me twice...
Does anyone now doubt the US Federal Reserve is serious about quelling inflation?
In case you missed it, the central bank raised its key Fed Funds rate by another 75 basis points this month. And Chairman Powell and his cohorts have promised more shock and awe ahead, should inflation gauges exceed targets.
The Fed’s moves added a new chapter to the worst year for bonds since the late 1940s. And they appear to have convinced many of the remaining stock market bulls to throw in the towel as well.
The S&P 500 accelerated its year-long decline and is now in the red more than -22 percent since the start of the year. The S&P 500 Real Estate Sector and technology-heavy Nasdaq 100 are much worse at -30 percent. And selling fever has caught up to dividend-paying stocks as well, with the Dow Jones Select Dividend Index down around -10 percent.
The S&P Energy Sector Index is still outperforming by a wide margin. But it’s also down more than 20 percent from the early June high. And after being strongly in positive territory for most of the year, the Dow Jones Utility Average is back to basically break even.
The Wall Street consensus is the Federal Reserve will continue to squeeze until inflation is reduced from upper single digit percentages to the central bank’s long-term target of around 2 percent—even if it means shoving the US and global economy into recession. And investors are re-pricing stocks and bonds based on that assumption.
But what if the Federal Reserve’s calculated decision to “go Volcker” is based on faulty logic?
That is following the example of the legendary Fed Chairman Paul Volcker of the late 1970s/early 80s-- increasing benchmark interest rates at an unprecedented pace and accepting whatever damage there is to the economy and investment markets.
Consider this: The global economy isn’t a line of numbers and equations you learned in Econ 101. It’s 8 billion people constantly transacting with each other for goods and services. And as we humans are complex animals, the number of factors affecting the economy’s health and growth are multiples of our population.
The Federal Reserve and its central bank counterparts around the world do wield enormous power and influence.
But their ability to act extends to one and only one factor: The cost of money, mainly interest rates that consumers, businesses and governments pay to borrow.
During the pandemic, the Fed held interest rates low enough to encourage spending by making it cheaper to borrow. Now it’s trying to take a page from the 1970s by doing precisely the opposite in dramatic fashion, with the objective of cooling off inflation.
The consensus from Wall Street analysts, economists and investors to politicians and the press is the Fed will be able to wring out inflation so long as it’s willing to keep raising interest rates until the job is done. That’s largely based on the view that it was Federal Reserve policy alone that quelled 1970s inflation.
I wouldn’t argue the Fed’s actions then didn’t have a major impact. Volcker’s interest rate increases threw the world into its deepest recession since the Great Depression of the 1930s. In fact, the impact was so severe the central bank was forced just a few years later into a massive reversal to avert a total catastrophe.
But those of us who were students of the stock market 40 years ago will also remember that the central bank wasn’t the only player in the fight against 1970s double-digit percentage inflation.
President Reagan’s willingness to take on powerful labor unions—though vilified by many today—arguably took a big bite out of the wage/price cycle inflation that had become endemic in the US economy. His passage of historic tax cuts and continuation of President Carter’s deregulation policies helped restore investor confidence that had badly eroded during the 1970s. And perhaps most important, revived investment in energy and natural resources ultimately boosted supply enough to reverse years of persistent and rapid commodity price inflation.
Here’s some irony of the highest order: The Volcker Fed’s dramatic interest rate increases likely slowed down the investment needed to bring basic commodity prices and therefore inflation under control—as higher interest rates made it prohibitive for producers to borrow and crashing prices tanked their operating cash flow.
Inflation did decline steeply at least initially. But the factors depressing supply that had driven natural resources prices higher were strong as ever. And when the central bank eventually reversed course in the mid-1980s, prices recovered with a vengeance and inflation along with it.
Sound familiar? It should. Since this summer, the rapid price increases for oil and other resources like copper have reversed sharply. But that’s entirely because of concerns a recession will cut into demand.
In contrast, the supply deficits that drove those rising prices are still very much with us. In fact, commodity producers across the board are going to be more determined than ever to keep holding the line on spending, if not to reduce it—as the cost of borrowing has become prohibitive and selling prices of oil and other commodities have dropped sharply on recession fears.
And rising interest rates along with rising recession demand risks have already provided yet another big incentive to spend less in other sectors as well. That includes real estate, where what was already a shortage of many property types such as apartments will only become more acute as investment dries up further.
What’s it all mean?
Simply, falling stock prices are an opportunity for investors to build and increase positions in the sectors that were driving inflation before the Federal Reserve embarked on its current mission.
And that definitely includes energy and real estate.
Stock prices are still likely to drop more in coming weeks as weaker hands fold and odds of a recession grow.
So invest patiently but persistently.
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Hurry though! You’ll want to know your moves before things bottom out.
Wealth is waiting in the wings!
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Roger S. Conrad