Interest Rates, Inflation, And Household Net Wealth

September 16, 2022

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The risk of yet another policy mistake, already uncomfortably high, is increasing.
Mohamed El-Erian

Jay Powell is as out to lunch on positioning Macro Tourists for a recession as he was for “transitory” inflation.
Keith McCullough

This week’s inflation number was just 0.2% different from expectations but the S&P 500 fell over 4% on the day. The biggest one day move since March 2020. This data sensitivity is clearly related to the Fed’s current focus on closing the record gap between inflation and interest rates.

The chart below shows that the Fed’s inflation error is creating record volatility in Household Net Worth, which over the last 2 quarters is beyond even that of the GFC in 2008.

The chart also suggests that core CPI will now likely fall dramatically, but it is unwise to take any simple correlation or projection at face value.

This Weekly Insight examines the paths of inflation and interest rates, and the critical levels that investors need to watch for.

The table below compares the current Fed Funds Futures interest curve with calculations of the CPI depending on different month to month progressions for the next year. The CPI could plausibly be below a 4% Fed funds rate by summer 2023.

This requires an inflation rate going forward of around 0.3% a month on average. Quite possible but it is a little below the projection of the most credible forecasts I have access to. A Fed funds rate above inflation may be the minimum requirement for Fed credibility. Even then there is no guarantee of a rate cut following soon after. So it may be a reasonable current expectation that a 4% or higher Fed funds rate could be with us for a long time. This is not that far from where interest rates are now discounting, although a little higher than current levels.

Are The Risks Balanced Around This 4% Projection?

Fiscal policy could offset the Fed’s demand destruction inflation solution

Judy Shelton’s Wall Street Journal article explains:

If you were expecting Jerome Powell to unveil an elegant new intellectual framework for monetary policy in Jackson Hole, Wyo., last week, the Federal Reserve chairman’s speech on the need for “forceful and rapid steps to moderate demand” set you straight. But the Fed’s determination to pummel growth will only make matters worse so long as misguided fiscal policies engorge the money supply.

Welcome to the era of good-cop, bad-cop tactics from major government institutions. Fiscal and monetary policy are now working at odds to fight inflation. The Fed could crush demand by raising interest rates to stratospheric levels only to have a spendthrift White House and complicit Congress pump up consumer prices through fiscal measures that expand spending power—cash payments, subsidies, rebates, student loan forgiveness…

When asked whether fiscal initiatives or federal budget decisions will undermine their monetary policy objectives, Fed officials are apt to sidestep the question. That’s the problem: There’s no point relying on interest rates to control the money supply when government spending continues to exacerbate inflationary pressures.

This combination of excessive monetary and fiscal intervention has already led to higher inflation and a weaker economy.

Daniel Lacalle explains:

In the past three decades the result is always the same. The United States economy exits a crisis with significantly more debt, lower employment growth, weaker real wage growth and slower GDP recoveries. Why? Government spending on everything and anything for any occasion is the equivalent of an athlete eating cake to face the challenging curves and expecting to run faster afterward.

Excessive monetary and fiscal intervention have left higher inflation and a weaker economy. Rate hikes may help reduce inflation, but permanent deficit spending will continue to erode the purchasing power of wages and deposits.

The United States seems to be on its way to a private sector contraction of unprecedented levels as it may affect all relevant industries at the same time. The divergence between the ISM indicator and the SP Global PMI indicator also shows another worrying trend: large businesses are doing fine in a high inflation-low growth economy but small and medium enterprises, which create around 65% of employment, are in deep contraction.

Some day we will understand that supply-side measures create less headlines but have a better impact on the economy than a constant increase in government size and spending followed by more debt, more taxes, and more inflation.

Supply measures are a better solution to a supply crisis, but policy is short sighted here too. Consider the energy supply crisis

The EU’s proposal would tax the extra income generated by oil and gas companies in the EU compared to what they made in the previous three years, a period that included the start of the Covid-19 pandemic and the ensuing drops in demand, prices and profits. The windfall charge is proposed to be temporary.

The tax is part of a raft of measures proposed by the EU to funnel profits from the energy industry to alleviate the burden of high prices driven by Russia’s restriction of natural gas supplies. The proposal could create uncertainty that deters companies such as Shell Plc, TotalEnergies SE and BP Plc from spending on new production, according to Christyan Malek, JPM’s global head of energy strategy.

When Europe faces an acute energy shortage it is short sighted to tax supply efforts while financing demand through adding support. These kinds of measures may be popular in the short term but distorting price and demand in the short term at the cost of providing greater supply over time is counter productive in the long term in a supply crisis.

In the US, government energy intervention happens in a different way

Nearly 179 million barrels of SPR released over the last 12 months. 17% of oil inputs in the US. Even with 17% “free” oil, prices are still up 8% over the last 12 months. SPR was 38% of supplied US crude last week.”

With this new temporary source of supply, not surprisingly the oil and gas rig count has started to decline.

In the last six weeks, oil and gas rig count just contracted for the first time since 2020. Companies are not ramping up production even at the current energy prices. In fact, US oil production has been flat in the last months.

Summary

Economic policy is increasingly on tilt and muddled at best. Perhaps the issues of inflation and interest rates will resolve themselves and turn out to be temporary, but stable and healthy growth and inflation outcomes still appear to be a major uncertainty and investment accounts will need constant attention.

The last time the 2 year yield was this high was in November of 2007 when US debt was at $9 trillion. Now it is nearly $31 trillion. The Fed is playing with fire and a deep recession could well hijack the Fed’s inflation fight. Growth has already weakened significantly from the end of 2021 and on current settings growth is likely to continue to decline into Summer 2023.

Record interest rate rises into a recession is an extraordinary policy.

Risk management is always important but especially in periods of instability and extreme policy settings.

Best Investors always prioritize risk management, so make sure you are fully aware of the best metrics, methods and execution to manage through these challenging conditions and be prepared for a range of outcomes.

If you’re not already a client of CB Investment Management, schedule a FREE consultation today. Let me use my expertise and multidecade experience to apply Best Investor risk management methods to navigate your portfolio for the uncertain and potentially challenging conditions ahead.

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