On Tuesday and Wednesday of this week, the Federal Reserve’s Open Market Committee (FOMC) will meet to set the rate at which banks can lend to one another. While Chairman Powell and the FOMC should be pleased with their ability to bring inflation down from its peak in June 2022, there is strong historical evidence to suggest that it would be a mistake to believe that the inflation dragon has been slayed. Currently, investors are debating whether the Fed should start to ease monetary policy with a cut in the Funds rate of one-quarter of a percentage point or a half of a percentage point.
We believe a quarter point cut would be more appropriate and fear that the Fed’s recent triumphalism on subject of inflation greatly risks another wave of price increases that would disproportionately hurt the poor and working classes of this country. Not only would a quarter point cut in the Funds rate be more appropriate, but it would also indemnify the central bank from potentially justifiable claims that the Fed is acting in a way to influence an election a mere seven weeks away.
At Strategas, a study of 30 countries over the past 100 years has shown that once an economy experiences one wave of inflation of over 6%, the chances of a second wave of over 6% are roughly 9 in 10. We suspect that there are two primary drivers of this phenomenon: 1) central banks and those who head them do not like to take the heat for any economic pain associated with fighting inflation; and, 2) workers continue to demand higher wages after the first wave has passed because the cumulative nature of inflation means their standard of living has deteriorated. The current machinists’ strike at Boeing and the potential for a longshoreman’s strike on the east coast in the next few weeks are examples of still-extant wage pressures despite a recent slowdown in the pace of price increases.
There are other more structural reasons to believe that the struggle to contain inflation will be a long one. First, it is important to note that the Fed increased the money supply as measured by M2 by 36% since the start of pandemic. If one believes that inflation is a monetary phenomenon, one could expect that general price level to also be up by 36% over time in the absence of large productivity gains or more monetary tightening. Since the start of the pandemic in March 2020 inflation is up nearly 22% as measured by the Consumer Price Index, outpacing wages as measured by the Employment Cost Index. This decline in cumulative real wages is a deterioration in the standard of living for the average American and is the primary reason why so many of our citizens feel so uneasy about the economy despite a strong stock market.
Second, the Biden/Harris Administration and other policymakers in Washington have shown absolutely no interest or willingness to slow the runaway freight train that is federal spending. Never before in the postwar era have we run budget deficits approaching 7% of GDP when the unemployment rate was below 7%. Up from 3.4%, the unemployment rate today rests at 4.2%. A complete lack of coordination between fiscal and monetary policy when it comes to dealing with inflation suggests that there will be nothing “transitory” about the increase in prices we have seen since the pandemic.
Third, like it or not, geopolitical tensions mean that the golden era of trade, from the time that China entered the WTO to the pandemic, are over. Long and complex supply chains that can arbitrage the costs of labor and materiel are likely to prove to be impractical in a world in which military power is more diffuse and the world more dangerous.
And, lastly, the Western world’s obsession to decarbonize its energy sources is extraordinarily expensive. Despite the fact that the hood ornament for such efforts is the electric vehicle, a product unrivaled in its use of extractive materials like copper, lithium, and manganese, decarbonization is significantly more expensive than the use of fossil fuels. This is especially true for the roughly 1 billion people on the planet that do not have reliable access to electricity.
In short, there are reasons to believe that while the first battle against inflation as been successful, the war has only just begun. While the growth in inflation has fallen meaningfully from the near double-digit rates of June 2022, we are advising our clients to resist the urge to believe that the inflation storm has passed. Similarly, we are advising our friends who concern themselves with politics and are in the thick of the race for the White House to understand that inflation will not only remain an important voting issue come November, but also will also be a significant challenge for the next Administration whoever that turns out to be.
