The Fed vs. Inflation: The Battle Continues

Stagflation is the economic environment that’s most damaging to financial assets. The combination of a weak economy and high inflation hurts both stocks and bonds. We’re likely entering a period of stagflation. The economy is slowing because of the Fed’s actions.

The housing market probably has declined more than any other sector. Prices for many commodities are well below their 2022 peaks. Some sectors are suffering because inflation requires consumers to make choices, reducing or eliminating purchases of some goods and services so they can pay higher prices for others.

Despite the significant rise in interest rates and monetary tightening actions implemented by the Fed, inflation’s momentum is intact. The economy continues to create a lot of jobs, and businesses report that one of their biggest problems is filling jobs.

Unfilled job openings still exceed the number of unemployed people seeking jobs by a large margin. The result is that wages are rising at nearly the highest rate in decades. The jobs picture sustains high inflation.

We’re likely to have above-target inflation until the gap between job openings and the number of people out of work closes. Also, long-term trends that kept inflation low for decades are ebbing. Globalization and free trade are in retreat. Pro-business government policies are being reversed around the world.

Productivity is down. The Fed plans to restore its credibility on inflation, even if that inflicts pain on households and businesses. Because of the built-in factors pushing inflation higher, the Fed will have to tighten monetary policy enough to increase unemployment and push the economy into a recession.

Earnings and profit margins will have to decline for the Fed to achieve its goals. Current stock market prices and most analysts’ forecasts don’t reflect the likelihood of lower earnings and margins.

Financial assets, especially stock prices, have performed better than the economy for many years now. Stock prices can rise at a faster rate than the economy for only so long. I believe we’re in a period, perhaps an extended period, during which stock prices will underperform the economy.

The big issue is whether the Fed will tighten enough to bring inflation down to its stated target of 2%. It is possible the pain experienced by households and businesses will be too much for the Fed to bear. The Fed might accept an inflation rate of 3% or 4% and reverse its policy.

If that happens, we’ll have an extended period with a weak economy and above-average inflation. While most investors focus on interest rates and the Fed’s decisions on them, broader monetary policy is more important. The Fed supported stocks and the economy for years with quantitative easing, under which the Fed expanded its balance sheet by buying bonds and mortgages.

Quantitative easing injected money into the markets and economy, supporting stock prices. That policy has been reversed with quantitative tightening. The Fed is reducing its balance sheet and drawing liquidity from the markets and economy. Financial assets feel the effects of this change first and the most. You can follow the Fed’s quantitative tightening by watching the monetary base.

You should expect the higher market volatility of 2022 to continue. Investment strategies that worked well for the last 20 years won’t do well now. An alternative strategy is to be broadly diversified, holding investments that do well in different environments.

Another good strategy is to reduce risk by having a margin of safety in all your investments. Tactically increasing and decreasing holdings of different investments as the economy and markets change is another effective way to navigate this environment.

Another important tool in this environment is to sell short select investments. Our recommended portfolios include all these strategies. They should hold up well no matter what the Fed does.