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With Inflation At 7.5%, Why Jerome Powell’s Rate Increases Could Make Things Worse

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Inflation hit a 40 year high in January. This raises three questions: What is causing the inflation? Will the Fed’s expected interest rate increases relieve the pain of rising prices or make life worse for Americans? What should investors do about it?

While I lack a crystal ball, here are my best guesses:

  • Inflation is happening because demand for goods and services exceeds the supply (rather than because the money supply has soared)
  • The Fed’s interest rate increases could cause serious unintended negative consequences — a rise in bankruptcies, lower consumer spending due to the negative wealth effect of declining stock prices, a recession and rising unemployment
  • Investors with at least 10 years to wait for things to recover should buy money market and stock index funds and shed bonds

Inflation and Its Causes

Inflation — at 7.5% — has not been this high since 1982. As the Wall Street Journal reported, this brings back memories of what Paul Volcker did to try to cure inflation (which I will address below).

Fed Chair Jerome Powell contributed to a surge in the money supply. He kept interest rates low as the Fed aimed at minimizing the unemployment rate caused by the pandemic while seeking to keep inflation below 2%.

To further propel the economy, the Fed pledged to buy $120 billion worth of treasuries in September 2020 and in March 2021, the president signed a $1.9 trillion stimulus bill, noted the Journal.

The Money Supply Argument

Did all this money printing cause the spike in inflation? I think not — after all, the supply of money has surged since the financial crisis in 2008 and it rose even more in response to the pandemic. Yet for most of that 14 year period, inflation remained below 2%.

As Zvi Schreiber, CEO of Jerusalem-based freight booking platform, Freightos, and author of Money Going Out of Style, told me in a February 16 interview, “The Fed has been printing money since 2008. Inflation is 7% to 8% but the money supply is up over 100% — the money supply was $1 trillion until 2008, $3 trillion since the pandemic, and $6 trillion in 2022. M1 is even more dramatic.”

Why isn’t inflation higher? He does not blame the supply chain constraints. “The supply chain is a small part of it — 3% of the 20% of GDP represented by imported goods. Shipping costs have gone up many hundreds of percent since the beginning of the pandemic,” he said.

He attributes the lack of inflation to money in the hands of people who are not spending it. “If you look at the velocity of money you see it has fallen dramatically. For years, each dollar bill circulated through the economy seven times per year. In 2019 it was up to 11 times a year. In the pandemic, it dropped to one time per year — all this money is not being spent.”

He sees income inequality as the explanation. “The world is getting wealthier and wealth inequality is rising. Money printing is going to wealthy people who don’t want to buy stuff — instead they invest in assets like property, cryptocurrencies, and the stock market. Because of inequality, we print money and it doesn’t create inflation. Salaries for those who are buying stuff are going up to keep pace with inflation,” Schreiber concludes.

How Demand Exceeds Supply

If the soaring money supply is not the cause of inflation, what is? A leader in the logistics industry does not agree with Schreiber — instead, he sees a constrained supply chain as a key driver of inflation. As Ben Gordon, Managing Partner and CEO, Cambridge Capital and BGSA, wrote in a February 16 email, “Yes, supply chain constriction is definitely driving inflation.”

Gordon — who recently hosted a conference with 300 supply chain CEOs — sees two drivers of supply-chain led inflation:

  • Capacity shortages driven by “just in time” supply chain strategies. “40 years ago, supply chain expenses represented 15% of GDP. Today, that expense is just 7.4%. The savings all accrued to the consumer. But that benefit came with a risk: shortages. We are now confronting that challenge,” according to Gordon.
  • Soaring supply chain rates. In the decade ending 2020, freight rate inflation stayed in a narrow range below 10% a year. “In 2021, we saw rates shoot upward rapidly and violently, reaching nearly 27%. These cost shocks rippled through the supply chain...while fueling 6.8% inflation,” he wrote.

Supply chain capacity contributed to inflation because of an unexpected spike in demand at the start of the pandemic. For example, the global PC market soared 55% in the first quarter of 2021 as the number of people working and learning from home increased — a demand spike that the semiconductor industry was not prepared to satisfy.

The gap between demand and supply of chips is affecting the prices of goods other than PCs and laptops. According to the New York Times, the pandemic has driven a shift away from experiences like travel and restaurants and into durable goods — such as cars, electronics and building materials for housing — spending on which rose 25% in 2021.

Prices for some durable goods have risen much faster than the 7.5% rate of inflation. According to the Times, “Used car prices are up 55% over January 2020 levels. Over that same period, furniture and bedding prices rose 19% and laundry equipment became 33% more expensive.”

Effects Of Rising Interest Rates

The last time inflation was this high, Fed Chair Paul Volcker raised interest rates to nearly 22%. I wonder whether such a cure would be more painful than the disease.

Can Powell reduce inflation without a recession? If he did, it would be a first. As the Journal wrote, “No Fed chairman since Paul Volcker in the early 1980s has had to grapple with inflation this high. The risk for Mr. Powell and the nation is that his fight against inflation will cause a new recession, as Mr. Volcker’s did. Historically, the Fed hasn’t been able to push down inflation without a recession.”

I certainly hope we won’t need to go through a recession on the order of the one that Volcker orchestrated. According to the Washington Post, “Volcker [was] most famous (and infamous) for more or less single-handedly breaking the back of the persistent, spiraling, inflationary cycle that bedeviled the U.S. economy throughout the 1970s.”

To do that, he raised the prime interest rate from an already record high of 11.75% to 21.5%. This caused the worst downturn since the Great Depression which contributed to the ending of Jimmy Carter’s term in office.

How bad was Volcker’s recession? The nearly 11% unemployment rate reached late in 1982 remained “the apex of the post-World War II era,” according to a 2013 Federal Reserve History. [Unemployment has since surpassed that level — reaching 14.7% in 2020, noted to the Journal].

If Powell needs to cause a recession to control inflation, it is unclear how bad it would be. Schreiber expects it to cause bankruptcies and falling stock prices.

As he told me, “Rising interest rates will send stock prices down because of the higher discount rate on future cash flows. This will increase the risk of recession and the collapse of asset prices. Why is the Fed so blind about this? For those who have negative equity because of borrowing, the rise in interest rates will increase the risk [of bankruptcies — particularly for those who have floating rate debt.]”

My hope is that rather than relying on interest rate increases, the Biden administration will do some original thinking and come up with policies that help address the real causes of the current inflation spike.

To my mind, that would mean lowering the barriers to immigration to increase our supply of workers and helping provide the capital needed to increase production and shipping capacity to meet the surge in demand for durable goods.

Getting past Covid would also help. As Stefan Gerlach, Chief Economist at EFG Bank in Zurich, Switzerland, explained in a letter to the Financial Times, the spike in inflation is due to the pandemic — as well as the Russian threat to Ukraine among other non-monetary factors — rather than the balance sheets of central banks.

Ultimately, the solution to the inflation problem could come from a blend of adding to the labor force, patience with market forces that match supply and demand, and a hoped for lessening of geopolitical tensions.

As Kent Jones, Babson College Professor of Economics and Babson Research Scholar, wrote in a February 19 email, “Any efforts to improve the supply of workers in the US, domestic labor mobility, innovation efficiency and competition are in and of themselves good, and will tend to lower prices. Putting the [inflation] genie back in the bottle quickly will probably in this case take patience with market adjustments and luck with Vladimir Putin.”

Implications For Investors

Having witnessed economic downturns over the last several decades, I think investors should estimate whether they have at least a decade before they need the funds they’ve invested.

If they do not have this much time, they should consider lightening up on stocks before it becomes clear how much the Fed will tighten and how bad things will get in the world should Russia invade Ukraine. That’s because I think investors are still overly optimistic about how difficult things will get for stocks in the next couple of years.

If they have more than a decade, I think investors should not rush to the exits. They should regularly invest in a stock index fund, put several years worth of cash in a money market fund, and sell their bonds before rising interest rates drive down their value.

Sadly for investors, there is no bell that rings when stocks hit their nadir and resume their upward march in pursuit of their long-term 7% annual rate of return.

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