Last week, during the Fed’s wildly anticipated annual Jackson Hole meeting, Chairman Jerome Powell delivered hawkish remarks on the economy and the degree to which the central bank is going to focus, at all costs, to bring down inflation. He talked about the consequences of tight monetary policy and how it may mean a period of difficulty for the labor market and economic growth, but this cost is necessary to get inflation under control. In the 1980s, Paul Volcker eased up on their policy too quickly and inflation accelerated again. Eventually, it required a recession to permanently reduce inflation. Without beating a dead horse, inflation is a problem. It does not take a rocket scientist – or economist – to understand why prices rising rapidly on a wide array of goods and services is bad.
Inflation, in economic terms, means a rise in prices or a decrease in purchasing power. However, a massive misconception the market and investors may be overlooking is that the “inflation has peaked” narrative does not mean that prices are going back down to where they were. Inflation is measured by a rate of change – i.e. prices rose 8.5% in the prior 12 months and 5.9% when you exclude food and energy. Many believe inflation has peaked, which hopefully it has, however many do not appreciate that prices are likely never heading back to where they were prior to the pandemic.
In March 2020, the COVID-19 pandemic caused governments to lock down cities around the world. This froze the economy and caused a massive recession. To quickly stimulate growth and a recovery, government and monetary stimulus measures were enacted to create money and put it in the pockets of consumers to be used for food, shelter and general survival. Not to get too technical, but because of all these stimulus measures, one calculation for the money in circulation in our economy, or M2 money supply, grew by 40%. Simply put, M2 money supply represents all cash as well as savings, money market securities and other “short-term” cash like investments. The consequences we are now realizing, are that when you create new dollars, it makes your existing dollars less valuable. “… or a decrease in purchasing power” – sound familiar?
The problem, and this is where the misconception comes in, is that prices cannot decline to where they were without the money supply also declining back to where it was. With the inability to remove $7trillion from the economy (that is the amount of money created since the start of the pandemic) the Federal Reserve, as most know, has been raising interest rates to increase, among other things, the cost of accessing money. The effects of this take time, but eventually demand for spending on homes, and discretionary items will slow, and price increases will moderate. Simultaneously, the Federal reserve is slowly draining cash from the economy by allowing bonds to mature without buying additional bonds, which effectively takes money out of the system and reduces M2. These two actions are how the Fed is aiming to slow inflation back towards their 2% goal. It is important to note that this fall, the pace of allowed “roll offs” will accelerate which could put strain on areas of the market that are used to easy money.
The big caveat here, is that the Fed’s goal is not deflation to the point where prices decline back to where they were – that will likely never happen. Before someone points out how gas or oil prices have declined in the last three months, food and energy are far more impacted by supply-side dynamics than demand. For example, if there is a draught in Mexico and the supply of avocados declines dramatically, should we attribute the rise in avocado prices to inflation? No – this is temporary. At any rate, the only way deflation would occur is typically during extreme demand destruction, often found in a recession where many lose their job and cannot afford even basic goods and services.
So, what does this mean for our lives and the economy? The Fed has indicated they will likely keep hiking rates and hold rates higher for longer to squash demand enough to calm inflation back to a 2% target and historical norm. There was newfound optimism the last two months that the economy can withstand these higher rates for longer and avoid a recession. We, however, would urge caution as a soft landing is not a common occurrence in history and the market seemingly agrees.
In our portfolios, we remain focused on positions we feel can endure a higher interest rate and slower economic growth environment for potentially years ahead. We expect volatility to continue, as each economic data point is scrutinized in fears of showing a more pronounced slowdown than expected. The good news is that the market is forward looking and will rebound long before the economy looks and feels better to us. Also, volatility creates opportunities for long term investors. Our focus on high quality and healthy cash flows can add value to portfolios at times of market stress.
If you have questions or would like to discuss this topic further, please do not hesitate to contact us.