Since it is the 50th anniversary of the greatest movie of all time, “The Godfather”, I will be stealing quotes from the first two “Godfathers” for a bit and I won’t apologize for it.
At this point in time of history it is very hard to talk about business as usual. There is nothing usual about the times we are living in and I know that if you have been watching any business news over the last 30 years, the word unprecedented pops up a lot. hHowever, these truly are unprecedented times.
Covid 19 struck and it really has only started letting up after 25 months of disrupting pretty much every facet of life as we know it. Then Vladimir Putin decided to test the strength of NATO and the West by invading Ukraine. Those two things alone would qualify as unprecedented (in terms of this generation anyway) and when some clarity began to appear with Covid we reached into a new phase of uncertainty with this unwarranted invasion and subsequent war.
Markets typically hate uncertainty and lack of clarity is a bull market killer if ever there was one. If you look back to March of 2020, that was pretty much the case. Covid was building up steam and the administration was not even remotely prepared for it. Honestly, how could you be? When they finally got there act together and came up with a coherent plan, markets rallied and regained all that was lost and then some. Even though the economy was knocked on its rear, markets remained convinced that the economy would recover and the economy did recover, somewhat. There was some sort of direction by politicians and state agencies to get people safe and get people back to work and the expansion was back on.
I may be less and less in the majority on this but I still believe that equity markets are pretty good at predicting future economic realities and this was a case where the equity markets got it right.
Now to something almost as sinister and even though we really have no clue what Putin’s next move will be or what his ultimate goals are, the markets are telling you that what you have to worry about is not Vladimir Putin but inflation and slowdown in US economic growth.
If investors truly felt that the situation in Ukraine was going to escalate into something resembling WW III, you can be sure that their money would not be looking to find bargains in these selloffs. What we would have is a flight out anything with risk into something that will do well in more precarious times. Yes, I know that there has been a rotation out of certain sectors but that was in place before the invasion. However, it is not a wholesale flight to safety that a World War (or something close to it) would instigate.
What we are seeing is a market that believes inflation is a much deeper problem and that the Fed will act but not act in such a way as to deal with it head on and the Fed will take these smaller steps to mitigate inflation. I have said it before, I believe that if the Fed feels that raising interest rates is going to quell inflation, get it over with quickly. Or, dont raise rates at all. Most economists will agree that raising rates too quickly and too harshly will do more harm than good, but I don’t feel that way and my reasons have no data points, just common sense.
Inflation is caused by too much money chasing too few goods. Correct. Fed monetary policy has helped spur demand for 7 years plus. Correct. We had a pandemic that threw the supply/demand equation for a loop. Correct. Then we had a Federal Government that pumped cash into the system at unprecedented levels. Correct.
OK, now take out the Fed monetary policy being accommodative. It isn’t. Take out the Federal Government’s spend and spend and free money policy. It ended over a year ago. Take out the pandemic as businesses go back to being businesses.
What do you have left? Residual inflationary pressures. A cycle of higher wages forcing producers to charge more for their goods and services. That is a much more typical inflationary scenario.
The fact that wages have not risen as fast as inflation is deflationary is completely overlooked here. Again, it’s very simple. If rising wages don’t keep up with rising prices, demand slacks off. It may happen slowly but when your dollar buys less you end up buying less.
Throw in rising fuel costs and households will have less money to spend on other things. Again a demand suppressor.
The Fed raising rates just 25 basis points will do little to nothing reducing inflationary pressure. Markets have priced that in already and it won’t be raising rates that soften equity prices anyway, it will be slowing earnings growth. A 50 basis point rise will impact borrowing short term and expansion plans may be adjusted so there is a possibility that it can slow down inflationary pressures but the more important aspect will be the signal it sends to the market and yes, markets would react poorly but I think that impact will be short lived and everyone will readjust expectations.
In summation, I can see two scenarios that will slow inflationary pressures. One, do nothing and let inflation slow demand until an equilibrium is reached. Two, The Fed raises rates significantly the first go around and knocks everyone for a loop. The initial pain will subside and growth will take a hit but so will prices.
Oh, and then there is what actually will happen. The Fed will raise rates by 25 basis points. They will give a 20 paragraph explanation that boils down to, “We are taking a wait and see attitude” and we will be in the same spot we have been for 18 months, watching prices rise on a weekly basis.
Excellent! Powell is not Volcker!