In our first post, Living With Inflation, Part 1: How Did We Get Here?, we provided 6 main causes of the inflation we are currently observing. In Part 2, we will provide a summary of what is being done to bring inflation under control by the Federal Reserve.
The chart above shows how inflation has jumped over the past year or so to be approximately 8.1% in May. The CPI is known as the Consumer Price Index, and measures how prices change (as a %) compared to the prior year.
Federal Reserve Plan of Action
The Federal Reserve Bank (the Fed) has two mandates. The first is to control inflation, and the second is to promote full employment. The Fed’s target inflation rate is 2%, and their goal for the unemployment rate is 4%. Of the two mandates, controlling inflation is typically understood to be the highest priority. To accomplish this, they have gone from Quantitative Easing to Quantitative Tightening. The Fed has two main tools that they use for Quantitative Tightening: 1. Raising the Federal Funds Interest Rate and 2. Reducing the Federal Reserve Balance Sheet.
1. Raising the Federal Funds Interest Rate
According to the CME Group’s Fed Watch Tool, the market has priced in expectations for Fed Funds rate hikes of 50 basis points (bps) in June and July followed by two more 25 bps increases in September and November. This would bring the Fed Funds rate to a target of 2.50%-2.75% by the November election. Since these rate hikes have already been “priced in” to the market, we have seen bond yields and equity valuations change to reflect these expectations. Rising interest rates from the Fed work their way into consumer debt, mortgages, business loans, and the bond market with the intent of slowing the economy and thus reducing inflation. When interest rates are higher, it restricts the money supply, constricts the amount of business expansion and overall demand for goods and services. For consumers, higher interest rates may slow down the housing market and auto market by making things more expensive to purchase. It will also likely limit discretionary purchases as access to cheaper money (through borrowing) diminishes. For companies, higher interest rates typically will cut into their profit margins and limit expansion. In some cases, it may lead to layoffs as a way to reduce expenses. The Fed understands that this is an unpleasant by-product of this policy, but since unemployment is 3.6% the economy can afford to shed approximately 600,000 jobs and still remain at “full employment” of 4%.
2. Reducing the Federal Reserve Balance Sheet
In the 2008-2009 financial crisis, and again in 2020-2021 (during COVID-19) the Fed financed U.S. Government stimulus payments by buying U.S. Government Treasury Bonds and they purchased over $1 Trillion in Mortgage-Backed Securities (MBS). Between these two periods, the Fed’s balance sheet ballooned from just under $1 Trillion to over $9.4 Trillion. As a result, they enabled enormous government spending which flooded the country with cash, influenced a general decline in the level of interest rates and mortgage rates. Excess cash went into the equity markets and propelled one of the longest bull markets in history. Brokerage accounts, IRA accounts, and 401(k) plans all experienced growth in balances, leading to what the Fed referred to as a “wealth effect.” Since about 70% of the US economy is driven by consumers, you can see how this is stimulative.
Year to date, the Fed has been working to slow the purchases of Treasuries and MBS in an effort to reduce its balance sheet. According to the St. Louis Federal Reserve, “the Fed will reduce its securities holdings by not reinvesting the funds it receives from maturing securities.” While this approach is intended to help reduce the money supply and inflation, the Fed also has stated that it will monitor the situation closely and “is prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments.”
THe above chart shows the Fed tightening cycles since 1977 and the impact on the markets.
Since the 1970’s the Federal Reserve has previously had 6 Quantitative Tightening Cycles as a natural way of controlling inflation. These cycles have averaged 18 months in duration, and the S&P 500 returns have been positive 4 out of 6 of those cycles as noted above. Although inflation can be very challenging, the past has indicated that the U.S. has been able to manage through and reach new highs in the market. We do anticipate higher interest rates during this period, which will likely affect housing (mortgages), auto purchases, credit cards, etc. We also expect continued upward pressure to prices especially in food and energy. Economists at the IMF and Fannie Mae have projected that inflation has already peaked, but will remain elevated and finish the year in the mid 5% range. Further, Fannie Mae estimates that housing price appreciation will have slowed from 20% growth to 10% by year end, and return to a normalized 3% growth in 2023. While each inflationary period is unique and unpredictable, our goal is to help our clients navigate these periods of volatility while helping them to stay focused on achieving their long-term objectives.
In our next blog, we address Living With Inflation, Part 3: What You Can Do About It. If we can be of service to you and your family, please don’t hesitate to reach out to us.
The commentary is informational in nature and not intended to imply a specific strategy or course of action. Investment advice and recommendations are only provided according to each individual’s personal circumstances. Chancellor Wealth Management is an investment advisor firm registered pursuant to the laws of the state of Georgia. The firm is also registered to conduct business in the states of South Carolina and Texas. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright © 2022 Chancellor Wealth Management, All rights reserved.