Can the Fed really stop inflation

Taxing.  Stocks rose yesterday, snapping a losing streak, as traders bought the dip caused by last week’s swoon.  Lawmakers scaled down the astronomical tax hikes proposed by the Administration and investors cheered.

N O T E W O R T H Y

A pickle by any other name…  I am quite sure that I don’t have to remind you that inflation is a thing these days.  Prior to March of this year, the word inflation was as foreign as a Vegemite sandwich to most Americans.  But earlier this year, that feared beast from the days of yore awoke, sounding alarms throughout the land.  It was the bond traders who first recognized the early signs of it in late 2020, pushing yields up from historic lows.  By the end of Q1 of this year, 10-year yields had risen from their August 2020 lows of 0.50% to 1.74%.  For the record, that’s an impressive move in any situation.  So impressive, that soon the academics began to sound the inflation alarms.  Then came the Fed who noticed the very same economic numbers we were all looking at.  We were all looking at those CPI and PPI numbers ticking up but no one seemed to care.  Why?  Well, because inflation has not been part of the US zeitgeist for so many years.  Sure it had a quick spike up in 2008, however within weeks the economy was registering rapid disinflation leading to temporary deflation. Trust me on that nomenclature. Prior to that brief episode, which you probably didn’t even know about, the last time the US experienced palpable inflation was in the early 80’s.  So, it is no wonder that when the alarms started ringing, most of us just ignored it like we might a fire drill. The Fed itself was initially in denial blaming the large percentage gains on base effect, which makes changes look bigger when starting from such a low point… that low point being last year.

So here we are.  We are all, I hope, quite aware that inflation is real. That is a polite way of saying that stuff is getting more expensive. The increases in prices are not localized to some narrow obscure commodity, but rather they are almost across the board.  The commonly accepted cause behind inflation cites two primary drivers: 1. Increased demand in the wake of the pandemic shutdowns, and 2. A supply chain in disarray, causing supply shortages.  Increased demand and decreased supply are the most effective causes of inflation. Let’s get back to the Fed, whose job it is to fight inflation.  The markets eagerly await the Fed’s next move which is expected to include the first steps to cool inflation.  In this case, that first step would be to taper bond purchases.  Ultimately, and farther down the line, the Fed will raise key lending rates.  This is nothing new as the Fed has effectively controlled inflation with interest rate hikes for decades.  The problem with interest rate hikes is that it is a tool which is designed to slow down the economy. Higher borrowing costs cause companies and ultimately consumers to buy less.  The pullback in demand reduces upward price pressure at the cost of slowing down the economy.  In case you haven’t noticed, though the US economy is certainly recovering, it is far from being on stable legs.  Just last week, a gaggle of bulge bracket investment banks and economic think tanks all lowered their Q3 and Q4 GDP growth estimates, citing the Delta variant surge as the cause.  Regardless of the cause, consumer confidence has noticeably declined and PMIs have pulled back considerably as well.  These two leading indicators, alone would be enough to raise an eyebrow in a normal situation.  If you add a stubbornly high unemployment rate to the mix, you are likely to raise both eyebrows.  If the Fed begins to pull back on stimulus, it is quite possible that consumer demand will diminish somewhat.  But what about driver no. 2 from above, the supply chain.  Higher interest is certainly not going to fix that problem.  While it seems reasonable that the supply chain will simply mend itself, it will certainly not happen over night. Experts initially expected the supply chain seizures to subside later this year but they have recently begun to push those ETAs out into 2022.  It’s not just the experts, but companies themselves who have warned us in their most recent earnings announcements that supply chain problems will continue to hamper their efforts well into 2022.  The Fed is unquestionably at an important crossroads when it comes to policy.  Governors are concerned about inflation getting the better of us and have increasingly been calling for a quick tapering.  Why quick?  So they can get on to raising rates sooner.  If it pushes on the brakes too hard too fast however, the Fed risks derailing the recovery and even potentially causing a recession.  In case you were wondering, the Fed can and has caused recessions in the past. While a recession can certainly be a cure for inflation, I am not so sure that we want that type of medicine right now.  Worse than that, the whole thing can go wrong and we can end up with stagflation, a situation which includes a slowing economy combined with high unemployment and high inflation. The Fed is indeed in a pickle.  We will get CPI numbers today which are expected to show a monthly deceleration of price growth.  The Fed will meet next week to discuss its next moves.  The meeting will not be an easy one.

THE MARKETS

Stocks rose yesterday as investors bought the dip while gaining comfort from scaled back tax hike proposals coming from Congressional negotiations on the proposed spending bill.  The S&P500 climbed by +0.23%, the Dow Jones Industrial Average rose by +0.76%, the Nasdaq Composite Index slipped by -0.07%, and the Russell 2000 Index traded up by +0.59%. Bonds rose and 10-year treasury yields moderated by -2 basis points to 1.32%.  Cryptos had a wild day on rumors surrounding Walmart’s use of Litecoin, which were ultimately debunked. Cryptos ended the day down by -1.45%.

NXT UP

– Consumer Price Index (August) is expected to have risen by +0.4%, slightly slower than the prior month’s +0.5% rise.  The annual growth is expected to come in at +5.3%, down from July’s +5.4% increase.

– Apple is expected to unveil a number of new products today and Chevron will discuss its low carbon goals.

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