Inflation on All Fronts

Inflation is a monetary phenomenon and in the short term can be affected by supply/demand dynamics.  The Investment Policy Committee of Clearwater Capital has written extensively about the dramatic rise in the M-2 Money Supply over the last two years emanating from fiscal spending which ‘flooded the world with cash’ following the COVID shutdown of the economy.  We are not debating the merits of the policy, but have been highlighting the affects of fiscal spending and the monetization of U.S. Debt through the Central Bank. 

The Federal Reserve Bank (The Fed) has a dual mandate – full employment & stable prices.  Put simply, keep interest rates low to drive full employment and keep interest rates high to slow inflation.  The Fed has taken emergency actions to bring the Fed Funds Rate to effectively zero over the last two years in favor of full employment.  Low policy rates have led to borrowing and thereby further expanding cash in circulation leading to inflationary pressure. 

The Federal Reserve has a target of roughly a 2.0% inflation rate, but the latest reading from the U.S. Bureau of Labor Statistics on February 16, 2022, reads, “Consumer prices up 7.5 percent over year ended January 2022”.  It’s no surprise to anyone that inflation is hitting all segments of society.  So, the question is not IF the Fed will raise rates, but when and by how much. 

Geopolitical implications for Fed Policy and Inflation are two-fold:  First, raising rates in the face of Russia’s aggression into Ukraine while Russia threatens the world over intervention seems to be a political challenge for the Fed.  ‘What If?’ scenarios circulating everywhere would lead the Fed to potentially demonstrate caution in raising rates too quickly.  Afterall, if they raise rates only to have a global slowdown, that is problematic. 

The flipside is, if the Fed is slower to raise rates and allow inflation to run higher, that is evidence of a strong economy in light of war in Ukraine.  We believe they will take the latter approach and be incremental in their steps, right or wrong.  This approach is currently reflected in the Futures Markets, where the probability of only one increase in the Fed Funds Rate to 0.25%-0.50% (from currently 0.00%-0.25%) is currently (2/28/2022) just over a 90% probability and illustrates a step in the direction without over-stepping or moving to fast too soon.

Source: CME Group

Second, geopolitical supply/demand affects will increase upward price pressures.  We can see in the Consumer Price Index (CPI) from the Bureau of Labor Statistics that Energy is already a significant contributor to inflation; and, we expect it will only become more strained given sanctions and the reduction of oil & gas supply from Russia.

Therefore, if the Federal Reserve Bank moves more slowly (thereby allowing inflation to run higher) plus our belief that energy prices will increase costs of everything requiring transportation, the anticipated result is inflation continuing at a ‘higher than normal’ level for the foreseeable future.