Slaying Inflation

| April 21, 2023

Many equity bulls have convinced themselves that the Federal Reserve (Fed) will cut rates by 1% before the end of the year. I don’t think so, even though I understand how anyone born after 1960 has been conditioned to expect a Fed bailout. Holders of this view wish to get ahead of these cuts, particularly since the Fed has begun cutting rates before the onset of recessions since Y2K. What happens depends on how persistent inflation is.

Consumer prices as measured by the Consumer Price Index (CPI) rose from 1.58% in 1965 to 3.01% in 1966. Inflation hit 5.8% in 1970, 11.05% in 1974, and 13.55% in 1980.* Along the way, the CPI pulled back many times before the Fed finally crushed inflation through punishingly high rates in the 1980s. Few people who hold important positions in finance today have ever experienced the combination of high rates, high inflation, and high unemployment that those of us born before 1960 lived through.

My best guess is that the Fed will hike rates by .25% and hold rates steady until we have more clarity that inflation is defeated. The inflationary period that lasted for nearly two decades required raising rates during recessions, not before recessions as we have become accustomed to. Cutting rates would likely depress the dollar, which would be inflationary. It would also stimulate the economy, which would also put upward pressure on inflation. Fed chairman Jerome Powell knows the history of what happens when the Fed cuts too early. He does not want to begin a decades-long inflationary cycle.

Paul Volker’s success with inflation in the 1980s led to decades of economic growth, low inflation, and even balanced budgets. Given the Fed’s dual mandate to control inflation and protect jobs, our current labor shortage elevates the importance of controlling inflation, even if that means triggering a recession.

Our economy is strong and many of the contributors to inflation are easing. I do not believe that the question is between a recession and no recession, but how deep the recession will be. I believe that it can be a short and shallow one and that we do not need to kick off an inflationary cycle to protect the economy. Instead, I believe that vast amounts of unspent federal money will offset Fed hikes.

Nobody knows for certain, which is why our clients have diversified portfolios. Anthony and I have overweighted to international securities to protect against the possibility of a secular change in the strength of the dollar. We are also continuing to move away from corporate bonds that will be negatively impacted by rising rates and the likelihood of a downturn. Even if Anthony and I are wrong about rates and the recession, government bonds and government agency bonds pay very well right now and we continue to be invested in equities. If we do have a recession, we hope to be positioned to take advantage of any price declines in corporate bonds or stocks. Time will tell.

* Inflation, consumer prices for the United States (FPCPITOTLZGUSA) | FRED | St. Louis Fed ( Federal Funds Effective Rate (DFF) | FRED | St. Louis Fed (