August CPI report released in Mid-September showed us inflation YoY at 3.7%, well below the 8% highs we were battling a year ago.
Let me be clear, the last 3 years of up and down turbulence, both in the equities market and real economy, are predominantly driven from a supply side issue. Supply contractions from the onset of the pandemic led industry managers to over-order, short term boost of inventory levels, and “wait and see”.
A slowdown in all things global economy/supply chain means supply has been impacted. Full stop. Yet, here we are 18 months into the Fed rate hike cycle and we have failed to clearly state that the Fed’s monetary policy tools are, at their core, demand based tools. Why are we fighting supply side problems with demand side tools?
Simple economics teaches us a reduction in supply, ceteris paribus, means prices go up. Inflation. Now pour on gasoline from the Fed printing trillions to stimulate an economy in all the wrong areas, and we have 8% inflation prints. Failing to be shocked is the correct response.
Oil seems to be the tricky commodity on the market’s mind. We saw oil hit highs middle of last year, sell off hard for 10 months, and now running again north of 90. Increased oil barrel costs translates to higher prices at the pump – one measure that is part of the CPI calculation. Increased refining costs and higher retail markups means the price will always go up; retail markups could hit 1$ in the next decade I assume. Gas is arguably the most inelastic commodity modern society purchases.
The most recent statements made by fed officials are rife with circular logic making it hard to even want to digest the jargon they mention. Do we really think hiking the US federal funds rate will curb the price of an oil barrel halfway around the world? Supply and demand out the window. Earlier this year OPEC surprised us with an output cut and Oil markets popped but the run in oil prices gathered strength mid summer and begin its trek to 90. Rates are a pathetic tool when it comes to oil. People need to put gas in their car to go to work, visit family, enjoy a weekend trip.
Depressing oil prices to ease your inflation readings is done with one tool; increase output and bump oil supply. The US reporting in late summer that they are hitting record output of oil bpd. This is the path. The off-board from oil to more and more green alternatives is a continued process that ultimately helps depress the price of oil, however that is a decade long process or more. Electric, wind, and solar has proven to be a capital intensive, timely crawl.
My issue lies with policy makers. They are simply, lagging indicators. Driving the car while looking out the rear-window. Using past data to guide their future decisions that impact the real economy, jobs, and price stability. Every action has a reaction, and Fed statements appear to blindly ignore this simple concept of human behavior. Albeit, Goolsbee has made some interesting comments regarding higher rates and recession risk tradeoffs. Arguing that the “nature of the policy environment we are in today is different”, which I agree with. Referencing 70s/80s policy can only help frame some thoughts, but it is no holy-grail or textbook to manage the economy in a developed society like the 2020s.
We are not overly long tech stocks and we are not long bonds.
The fed should cut, and do it sooner, without warning to the markets. The precedent of 2% inflation target is, in my wholesome view, a joke. The 2% concept came from New Zealand, with no academic study to support it- argues it came from an off-hand comment during an interview. Lets do basic math. If the target growth of GDP is 2-3%, I’ll use 3%, then that means the real economy grows at 1% (3% GDP – 2% inflation = 1% real growth). The average annual wage increased has hovered around 3% for decades, and only recently shown a bump to 5% in the last few years. Factor in increased benefits costs, deducted from employees wages, lets call it 2%. subtract out inflation of 2% from purchasing power and you can see where this is going. The real wages growth is a whopping -1%. Granted these are basic estimates, sure, not to oversimplify but the real purchasing power is in negative growth and has been.
But how did we have a decade long period in the 2010s with low inflation, below this 2% concept, in a ZIRP environment? Technology for one. Tech is ultimately deflationary – massive job creations behind it fueled a 14 year bull market.
Policy takes significant time to filter through the real economy. By last month’s reading, the real rate is ~1.5%. With the next inflation print anticipated to sink, this makes the “higher for longer” mantra confusing. The Fed also began this crusade with the “inflation is transitory” mantra, so it is hard to bank on any of their credibility now. Which makes me wonder if they really will stay higher for longer, only in the sense to regain their so sought after credibility, despite the damage it could do.
With a surprise cut the Fed can align rates with inflation, create a real rate closer to 75bps. This keeps policy restrictive, curbing inflation where it actually can, but it also signals to the market that we want growth and they shouldn’t delay investments in the future. Delaying investments in the future for many organizations means decreasing their output, decreasing supply. And depressed supply is what got us here in the first place. For every action there is a reaction.
Not to mention all the HTM assets on big org. balance sheets showing massive unrealized losses. A surprise cut in rates, a small one, will breathe life into fixed asset prices and ease some of the unrealized losses on those balance sheets. That will improve their overall willingness to invest or lend, further stimulating real growth. But why would we do that.
Businesses are adapting, changing forecasts, preparing for an increased uncertain future. Because they are told to do by their counterparts, customers, vendors – who think they must because the fed has stated “higher for longer”. The old age view of monetary policy is impacting the ability for the Fed to be agile. We have computers doing billions of calculations per second, but a fed that refuses to embrace real agility.
The nature of the environment is very different. In the 80s, debt to gdp was 25% or so. Hiking rates to break inflation as a strategy had merit. Today its north of 100%. Hiking rates imposes austerity on the federal budget, which is already a mess from over spending, adding 1.5trn to the deficit this FY and a forecasted 1.8trn next fiscal year. The tightening from 0bps to 500bps has made an impact, to architect a soft landing, policy should loosen slightly to signal the forward look. Not a backward look. We will need serious overhaul of what is considered sound economics, a grasp on integrated global markets, and effective policy tool management in the years to come if we are to navigate this new world order with success.
Nier Capital Group 