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Federal Reserve: Curing Inflation Through A Bitter Monetary Pill


Following the rapid economic and financial markets recovery from the Covid shock, inflation has emerged as the dominant economic issue facing American people and policymakers.


When inflation first broke out above its typical levels last spring, most economists saw it as “transitory”, or temporary, isolated to a few categories, and mostly caused by supply chain bottlenecks. Over a year later, inflation has not only persisted but accelerated, and as consumers we are now facing the fastest rate of price hikes in four decades. The national average gas price has topped five dollars a gallon for the first time ever. No longer isolated to a few types of goods, accelerating prices have broadened out to cars, housing, food, travel and an increasing number of spending categories.


Share of CPI Components Chart
*The above chart illustrates the various components of CPI and their year over year percentage change. CPI is an acronym for Consumer Price Index, a commonly used measure for inflation; data source is Strategas Research Partners

Clearly, economists underestimated this risk. As inflation threatens to spiral upward, the Federal Reserve faces a major challenge in reigning it in, let alone doing so without causing a recession—a so-called soft landing. Now that GDP growth has begun to stagnate, that Goldilocks scenario appears increasingly unlikely, although we cannot completely rule it out.

Taking a longer-term outlook however, there are reasons to be constructive about the prospects for the economy and investors. First, this may be unfamiliar territory, but it is not uncharted. The Fed managed to tame inflation worse than this in the early 1980’s, a key precedent that shows it can be done and also provides lessons for policymakers. Second, while prices may appear unconstrained, the Fed has hardly begun implementing policies to contain it. They have only just hiked interest rates for the second time, and the short-term policy rate is still fairly low compared with history or estimates of the neutral level. Furthermore, monetary policy takes time to take effect—something like a couple of quarters—so we have yet to see the full effects of their tightening efforts so far, not to mention those to come.


Tightening Fed Rate Cycle
*The above chart highlights the past timeframes in which the US Federal Reserve his tightened monetary conditions.

In the event that inflation does remain higher than what we are used to, it is also worth considering that both the economy and financial markets are dynamic systems with diverse constituents. In spite of what is now a bear market in stocks, companies in sectors such as Energy, Materials and Financial Services can weather and even thrive in a moderately inflationary environment, as can businesses with strong pricing power. Even in fixed income, which has fared worse than stocks this year relative to its typical volatility, lower prices mean higher bond yields, and interest rate hikes from the Fed provide better returns on cash. So there will continue to be opportunities available given a willingness and ability to adapt.
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