Inflation or Stagflation?

The Bureau of Labor Statistics reported that June’s inflation rate was .9% excluding food and energy. That was an increase of 4.5% over the past 12 months. With food and energy included inflation was up 5.4%; annualized, the inflation rate was 10.8%. Following that announcement Fed Chairman J. Powell reiterated the Fed’s belief that the current inflation rate is “temporary” while clarifying he was not saying current price increases would be retracted, just that inflation would not turn into a month-to-month inflationary cycle.

The Fed has been able to control inflation by being the buyer of last resort for bonds (treasuries, mortgages, and recently high yield corporates) and holding them on its balance sheet. Recurring inflation requires an increase of money in circulation and economic growth must increase more than the growth of debt. So, with Congress set to increase the US debt ceiling and to authorize an additional $4.5 trillion in debt, in theory, the greater US debt should constrain the velocity of money and inflation, at least in the short term.

In our view, skill and craft in monetary policy plus a good dose of luck will be crucial for the Fed to pull off a soft landing for the US economy. The facts are our government’s plan assumes more debt can be readily issued and that infrastructure spending will create jobs for all that want them. Unfortunately, with increased costs for food, housing, energy, and healthcare—staples necessary to live, —higher wages are a necessity. The Fed’s seems caught in a “catch-22” proposition. The new stimulus money will be put into circulation creating an extra challenge to control inflation without taking actions detrimental to higher economic growth. If the Fed begins to taper as they’ve already announced plans to do by reducing their debt purchases, interest rates will have to rise to attract new buyers. The ensuing perfect storm of higher prices, higher borrowing costs, and higher taxes could unsettle confidence and lead to a market correction. Moreover, it does not seem prescient to be raising debt service payments on yourself while fueling the very inflation you want to prevent even if done gradually, to say nothing of what too many dollars in circulation will do for our international competitiveness. Though time will tell when global supply chain matters sort out, for now we seem to be at the crossroad of two extreme pathways: rising Inflation or Stagflation—slow growth and unemployment with high prices. The Fed can shut down an inflationary cycle by employing sharp interest rate hikes as Fed Chairman Paul Volker did in early eighties. Stagflation however presents the dilemma that more spending pushes inflation higher while fighting inflation causes greater unemployment. It is likely to lead to a negative interest rate environment as is present in Japan and parts of Europe. The Fed would then have to revert to quantitative easing once again.

Our government’s economic priorities going forward are to:

  1. Raise the debt ceiling.
  2. Boost economic growth & employment by stimulus spending.
  3. Begin tapering by first selling off mortgages.
  4. Attempt tax reform but fall back on the “Sunset Provision” to raise tax receipts at the end of 2025.
  5. Sustain inflation a couple points above nominal interest rates to deflate the cost of US debt over the long term.

The debt ceiling has already been hit but Treasury has funds enough until October. Sometime after summer vacation Congress must raise the debt ceiling to accommodate the new $4.5 trillion stimulus spending with enough extra to take us another year, probably until after the midterm elections. Having driven mortgage rates below the average issue rate of their mortgage portfolio, the Fed’s window of opportunity to sell profitably is now open (lower rates make bonds with higher issue rates profitable to sell). Recent Fed announcements outline January 2022 as the beginning of tapering. This means by next spring we may see a rise in mortgage rates. Until then, economic growth should be robust excepting any lost productivity from the Delta variant of the Covid virus. Spending to rebuild our infrastructure will create jobs and be a set up for higher taxes, but the “sunset provision” in the 2017 tax bill means taxes can go up without Congress doing anything. The Arab cliché that “the enemy of my enemy is my friend,” applies to inflation as well. Ideally the Fed would like to have inflation erode the cost of repaying our debt gradually over time as the principal value becomes worth less and therefore easier to pay back. This entails letting the inflation rate rise while adopting policies that promote more government involvement in the economy to achieve goals of maximum employment, production, and stability. Specifically, it is Keynesian economics advocating government intervention with social spending policies based on the assumption that full employment can be bought by stimulus spending. Without monetary policy to control the amount of dollars in circulation, imbalances in trade lead to dollars being traded for other preferred assets and a falling value of the dollar. When this happens business investment slows, and productivity drops, while unemployment rises. The country then is faced with the Stagflation dilemma.

Navigating such markets requires monitoring of macro-economic events, especially with stocks, bonds & real estate assets largely overvalued. One must not only pay attention to the news but verify it by reading the full text and fact checking information from multiple sources to determine the truth. Because big institutional money games the markets, monitoring dark pools (institutional trades off the exchanges) as well as Market Maker volumes at the bid and ask is essential. Hedge funds and institutional traders have tens of millions to invest. They must build positions before they are required to file a public report. Monitoring their trades is a tell-tail sign of market direction and things that may come. The wild card is the Covid threat that may limit productivity for stimulus money spent. Our view is that conditions are not present for a market correction as we have low interest rates, pent up demand, stimulus spending and little competition for financial assets. Furthermore, we see many small & mid cap US companies and international opportunities to navigate to and are taking advantage of shock news that scares traders and momentum investors.

As a Total Return manager taking a conviction approach to buying ownership interests in companies, we seek growth at a reasonable price while striving to keep money compounding. We continue to stick to our investment discipline that has proven itself over time—the biggest element of it keeping careful watch during these unprecedented times. Thank you for your continued confidence. We are on watch and will take corrective action to your best advantage.