Question:  

What are your thoughts on how the Federal Reserve is handling inflation? 

Answer: 

The Fed has changed its view on inflation over the last year and a half from “it’s transitory and we can wait it out,” to their current risk averse position.  At the December 14th Federal Open Market Committee (FOMC) press conference meeting Fed Chairman Powell hinted that they’re willing to purposefully disregard better news on inflation and are willing to overdo monetary tightening to lower inflation. As a reminder, The Fed raises interest rates to weaken economic activity. Too many dollars chasing too few goods and services is one definition of inflation, and bringing inflation down to more manageable levels is the immediate goal.

The invasion of Russia into Ukraine sent oil and food prices sky-high. This continuing war further supports the Fed’s position to stay tough on inflation with higher interest rates. The Fed’s goal is to bring inflation down to a target rate of 2.00%. The two popular measures of inflation are the consumer price index (CPI) and personal consumption expenditures (PCE) price index.

The CPI measures changes in the cost of living by tracking prices of items like gas, groceries, clothing, and housing. PCE is used by the Fed for inflation forecasts as it can be revised more extensively than CPI. For instance, if the price of eggs goes up and people purchase fewer eggs, the PCE index will use a new basket of goods to measure consumption that may include other protein sources such as chicken or beans. This is called the substitution effect. The CPI is a basket of goods regardless of price or behavior changes. In essence, PCE tracks a broader range of goods and services. Typically, PCE shows lower inflation and a smoother path than CPI. Shelter and energy costs carry higher weights in the CPI index. This matters right now because the divergence between these two numbers is growing and could be clouding data influencing policy. Oil and food prices remain the wildcard in the equation.

Low inflation and low unemployment are the goals of the Fed. Managing this mandate after a pandemic and the war in Ukraine is a very difficult task. Raising interest rates to slow growth places pressure on the housing sector. Consumer demand for goods and services is less sensitive to interest rates but greatly influenced by inflation, but not immune to higher rates.

Consumer demand accounts for about 70% of the total economy and depends on income. Inflation reduces real net income and interest rates. The decision to save for the future or spend now is partially influenced by interest rates. If interest rates on savings accounts are too low today, individuals prefer to consume now if savings does not offer an adequate reward. On the other hand, if interest rates are high today, then they may prefer to save now and increase consumption in the future. The alternative to not saving is for consumers to consume more, even if they must increase debt to do so.

The Fed is using “Fed speak” guidance warning companies that a recession is coming in hopes of dialing back inflation today and into the future. They’re trying to change expectations or influence what John Maynard Keynes called ‘animal spirits.’ According to investopedia.com: “Animal spirits represent the emotions of confidence, hope, fear, and pessimism that can affect financial decision-making, which in turn can fuel or hamper economic growth. If spirits are low, then confidence levels will be low, which will drive down a promising market—even if the market or economy fundamentals are strong. Likewise, if spirits are high, confidence among participants in the economy will be high, and market prices will soar.”

The Fed is faced with a conundrum; it wants to slow the economy, but the economy isn’t responding. Housing and the goods producing sector are slowing in response to higher rates. In addition, the strong US dollar makes exports to the rest of the world more expensive and influences future production. Meanwhile, the service sector is still booming, and it doesn’t seem to be bothered by higher interest rates, at least not yet. The answer to your question is that too much stimulus took about one-year to show up in the economy as inflation, and higher rates will take time to have their desired impact. Pendulums tend to swing too far in either direction before finding a balance point while we wait for the Fed’s monetary tightening to achieve the desired effects. Stay focused and plan accordingly.