A No-Win Situation

15.09.22 01:09 PM By Cullen

Restrictiveness of Fed Mandate and Policy Limitations Setting Stage for Economic Disaster

On a single day last week, markets sold off to the tune of nearly 1300 points on the Dow - just under 4%.  This was topped by downward moves of 4.32% on the S&P 500 and 5.16% on the NASDAQ.

All of this was an appropriate - if sudden - reaction to the facts on the ground.  Market had moved up steadily over the previous two weeks, signaling the hopes of the market that a Consumer Price Index (CPI) reading would come out that confirmed the Fed was starting to get inflation under control.

What we got was the opposite.  Instead of a YOY growth of 8.1%, the read came in at 8.3%.  Nominally, the difference doesn't seem of much consequence.  But directionally, it was deeply troubling.  In July, Inflation actually got worse relative to previous year reads for July.  And this reading - indicating that the inflation fight is getting worse, not better, effectively ensured another 75 basis point hike of the critical Federal Funds Rate later this month.   

That is exactly what we got.  And the markets have been aggressively selling off since.

This last 75 bps hike was effectively assured because of the Fed's dual mandate: low unemployment and stable prices.  Statutorily, the Fed is asked to only concern itself with those two things.  As we are probably all aware, the unemployment rate is at the lowest levels since the 1960s, less than 4%.  With an unemployment rate so low, Fed Chair Powell and his team are left with only one thing to focus its attention on: stable prices.  And this CPI data - and likely the PPI and PPE data that is to follow in the next weeks - reinforce the notion that there's quite a lot of work to do to establish price stability.  Whether at 8.1% or 8.3%, there's still a lot of ground to cover en route to a "normal" rate on the order of 2.5%.

The Fed is now doing what it is obligated to do - using every tool at its disposal to bring inflation down.  The problem with this: it only has two tools, and those tools have generally been the wrong ones for solving the problem at hand.  

The Fed's two tools are the Fed Funds Rate and its balance sheet.    

The Fed Funds rate is its lending rate to banks.  As their rate rises, the banks borrowing from them need to adjust their rates up correspondingly.  When these rates ultimately reach businesses or retail investors, the higher interest rate constrains their willingness to borrow money.  This leads to cooling of the economy, as fewer items get purchased, fewer commodities are required to produce those items, and demand diminishes.

The Fed's balance sheet is its other tool.  In times of financial crisis, it has been empowered to buy financial instruments - especially treasuries and mortgage backed securities.  This activity has, in the past, created liquidity in the market when it would otherwise be constrained.  Thus, it "greased the skids" for banks to lend more money, in turn accelerating the market.  Now, as the Fed seeks to cool down the market, it has begun selling assets on its balance sheet. 

Are those two tools appropriate for solving the challenge at hand?  Put simply, no they are not.  They are tools for stimulating and constraining demand.  What we face at the current moment is largely a supply problem.   

Current inflationary pressure is largely driven by unique geopolitical events and a unique brew created by the related responses.  The first of these was Covid-19 and the related snags it created in global supply chains.  As the virus spread around the world, governments at the local, state, and national level called for lockdowns.  Moreover, the short term impact of Covid also led to some businesses going under.  All of this contributed to unreliable supply chains.  Many companies were forced to identify alternative sources of supply.  In some cases, this led to double or triple buying of certain goods in an attempt to ensure some supply reached demand.  Prices surged, as those companies that remained open were in prime position to take advantage of their pricing power with customers.  These higher prices would normally have an adverse impact on demand - but fiscal stimulus by the governments of the world and aggressive rate cuts by central banks both ensured that demand would stay intact.  In fact,  consumer demand generally soared.  Cheap rates and modern tele-presence tools enabled city dwellers to buy second and third homes away from the dense cities they previously called home, creating bidding wars in suburbs and vacation destinations.  Direct payments to  citizens ensured that demand for consumer staples and discretionary goods wouldn't dry up either.  In fact, demand for those goods would soar as the ability to spend that money on travel and entertainment was curtailed by Covid closures.  Once the economy reopened, it begat a boom in travel spending, where pent up demand was met by travel and entertainment companies that were happy to recoup losses during the pandemic. 

This unique combination of very accommodative policy to drive demand and constrained supply led us to skyrocketing prices across the market.  The Fed recognized this and began raising rates in early 2022.  Unfortunately, the genie was out of the bottle.  Inflation has proved far stickier and less transient than they'd hoped.  People who saw their wages increase during the pandemic and home values skyrocket aren't keen to see those values come down.  With the US being a 2/3 service economy, the wage impacts on inflation are huge.  Momentum in the real estate market also proved stubborn.  People who had only seen home prices go up - FAST - for years continued to buy.  In fact, the fact that rates were going up motivated certain buyers to move faster.  With 1/3 of the typical consumer's expenditure being allocated to shelter, the impact of higher prices for real estate is huge.  Those who couldn't afford to buy are forced to rent at higher prices, corresponding to the increase in the underlying homes and apartments.  Last but not least, the Russia's invasion of Ukraine added another unique constraint to the supply chain, as the farmlands of Ukraine and the oil fields of Russia were effectively taken out of the supply.   

So where does this leave us currently?  In a place where CPI has gone out of control.  The biggest pieces of this are food and energy prices, over which the Fed has no control.  Nevertheless, they remain the body statutorily obligated to control inflation, so they are doing the only things they can to tamp down inflation - raise rates and reduce the balance sheet.  This will eventually work.  Eventually, higher interest rates on everything will tamp down demand.  But it's a bit like pushing a box and doing it from an off angle rather than directly behind.  You'll move the box where you want it to go...but you'll expend a lot more energy and effort than if you were able to tackle the problem squarely.  And along the way, you'll cause that box to spin.  Our economy is that spinning box.