The Federal Reserve’s fight against inflation

Well, it looks like the Federal Reserve is not kidding around in its attempt to kill inflation. The problem is there can be a fine line between slowing the economy to lower inflation and slowing the economy into a recession. In my opinion, we’re already in a recession, and the administration just hasn’t admitted it yet. In his prepared speech from Jackson Hole, Wyoming, in August, Federal Reserve Chairman Jerome Powell said, “Yes, the Federal Reserve has, in fact, been squeezing inflation out of the economy,” and it would continue doing so “until the job is done.” He has continued to reiterate that statement without wavering.

The market reacted like you’d expect, and it’s been pretty ugly ever since. To find out why, you need to read a little deeper into his speech. His speech was quite good, actually. His thinking matters because the Federal Reserve chairman controls the economy—at least in the short term.

Obviously, over the longer term, it’s a bit more complicated. But his decisions on interest rates are the single biggest factor in the short-term movements of markets and twists of the economy. The classic definition of inflation, if you recall Economics 101, is too much money chasing too few goods. And the standard remedy has been to raise interest rates in an effort to slow demand. Of course, there is a fine line between slowing demand enough to cure inflation and doing too much and crashing the economy. It’s very seldom anyone has actually pulled that off without creating a recession. We’ll see.

The inflation of today is a combination of supply chain issues from the pandemic, bad decisions, global geopolitical problems, trillions of dollars of unnecessary monetary and fiscal stimulus for too long (which was a great overreaction to COVID-19), and even more planned deficit spending by the government going forward. It is highly doubtful, in my opinion, simply raising interest rates is going to be enough in the short run to kill inflation. At least Powell is trying to do something.

One of the points Powell made was his predecessors in the ’60s and ’70s didn’t fully appreciate this idea. With the passing of time, you remember a certain narrative, but it wasn’t really like that. The common narrative is the ’60s and ’70s were all inflation all the time, and the Fed just took the reins off and let it go. Then, Paul Volcker takes over in the late ’70s and early ’80s and comes down like a hammer and crushes inflation. This was the breaking point where it was just wild inflation followed by the hammer and then no more inflation.

Nice story, but it wasn’t exactly like that. The Fed did try to fight inflation in the ’70s. They just didn’t do it strongly enough or consistently enough. It was a haphazard approach, and that’s what Powell talks about in his comments. He says, “Look, they didn’t go in hard enough, fast enough, and so it wasn’t effective. It just prolonged the inflation.” And the longer inflation is prolonged, the longer it’s baked in. The more it’s ingrained into the economy, the harder it is to break. That spiral is hard to get out of.

When we finally broke out of it—when Paul Volcker came in, raised rates to the sky, and obliterated inflation—it was brutal. That early 1980s recession was one of the worst of my lifetime. I was in the early stages of my investment career, and I can tell you from personal experience it wasn’t much fun and was a big challenge to deal with.

It may not have come to that if the Fed had been more proactive in trying to nip inflation in the bud in the ’70s. We may not have had the harsh recession we had in the early ’80s necessitated by Volcker’s moves. Powell knows that. He doesn’t want to have to be the next Volcker. He would rather fix this problem now so that he, or whoever comes after him, doesn’t have to put themselves in that position before it becomes so bad. No one wants to do that again.

Of course, a lot of the inflation we’re suffering right now is directly the fault of the Fed keeping interest rates too low for too long and keeping the bond buying going for great quantities for too long. In my opinion, the Fed really lost their minds post-pandemic. That was fine for the first six months or so, but it went on for two years. We’re suffering the consequences of that now.

Maybe Powell will be the hero in all this if he pulls it off, but I can’t help but feel this is like the arsonist getting a medal for putting out the fire he started. I will give some credit to Powell in that he is transparent. He comes out and tells us, “This is what I’m doing, and this is why,” in plain English, with no room for ambiguity. That’s different from some of his predecessors, who liked to be opaque and make it complicated. I respect that but wish he had been a little better at his job two years ago. But it is what it is. At least he’s fixing it now.

Another issue that hasn’t been talked about much is the Fed’s determination to crush inflation at home by raising interest rates, which is inflicting profound pain in other countries, pushing up prices, ballooning the size of debt payments, and increasing the risk of a deep global recession. Those interest rate increases are pumping up the value of the dollar, which was already very strong and causing economic turmoil in both rich and poor nations. In Britain and across much of the European continent, the dollar’s rise is helping feed even worse inflation than ours. As I write this, the British pound hit a record low against the dollar. In today’s world, no country lives in isolation, and there are global consequences to almost everything.

Besides the personal pain for everyone, inflation matters in how we invest. Tech and growth stocks have been clobbered this year. Why? Because when you raise interest rates—with stocks valued based on earnings that may come decades in the future—those earnings become worth a lot less when discounted at a higher interest rate.

Without getting too deep in the weeds here, think of it like this: The higher interest rates go, the less valuable a growth stock is, and comparatively speaking, the more valuable a more mature company is. Because their profits are arriving today in the here and now. You’re not buying a future income stream years or decades in the future. The more the Fed raises rates, the more that punishes tech and various growth stocks. And the more it rewards, the more mature companies are throwing off lots of cash for dividends.

To be clear, I’m not suggesting we should abandon growth stocks, but we have to keep the Fed’s macro environment here in mind. If we know growth stocks are going to be facing headwinds, then we need to be careful about which growth stocks we choose. And if we choose them at all, then we need to make sure whatever trends we’re following are strong enough to overcome these headwinds in the long run. Right now, higher-quality companies are those showing the most momentum.

The bottom line currently is the Fed intends to break the back of inflation no matter what, and it’s probably going to get ugly. It comes down to whether they go all in and get it over with sooner rather than later or wimp out and go softer and stretch it out over a longer period of time. Personally, I’d rather take the hit and get it over with, but Powell didn’t call and ask me my opinion. Thanks for reading.