The Fed is way behind the curve

It has been making nervous noises but it has just started tinkering at the edges, hoping it doesn’t have to really crank things higher. Too many analysts/pundits and, indeed, central bankers are still much too sanguine that the current burst of inflation is transient

The fourth (or fifth) wave of the pandemic, which has surprised people in Europe and the US, could again create inflationary pressures, since the supply chain issues that remain difficult would be exacerbated in a few months.
The fourth (or fifth) wave of the pandemic, which has surprised people in Europe and the US, could again create inflationary pressures, since the supply chain issues that remain difficult would be exacerbated in a few months.

Monthly US inflation, which had not crossed 5% over the past 40 years, shot up to 6.18% in October 2021; the last time it climbed to this level was in 1973, triggered by the OPEC oil embargo, which—hold your breath—pushed oil up from around $4/bbl to a high of $13/bbl the following year. Significantly, even after the embargo ended (in 1974), oil prices remained high and inflation shot to over 11%. The Fed, under Paul Volcker cranked up interest rates to as high as 18% to “tame the beast”, bringing inflation back down below 6%. But, just as the US economy was showing signs of recovery, a second whammy—the Iran-Iraq war and the Iran oil embargo—hit the world. US inflation peaked at nearly 14% in 1980 and oil prices climbed to nearly $40/bbl before retreating. The US Fed Funds rate peaked at 20%.

The history lesson is important to enable you (a) to be as amazed as I was to see the remarkable numbers—oil at 4 dollars!—that were normal at the time, and (b) to realise that when inflation starts to rise, it takes a huge effort, and often years, to bring it down. In my view, too many analysts/pundits and, indeed, central bankers are still much too sanguine that the current burst of inflation is transient.

In addition to oil, which, while steady, is quite high—nearly 35% higher than its last 5-year average—there are a huge number of uncertainties that have been cranking prices higher across the world. First in line is the litany of supply chain issues, with particular pain in shipping, that have been precipitated by the lockdown(s) over the past few years.

Then, there is the surprising increase in people, certainly in the developed markets, who are backing away from work—the US labour force participation rate, while having risen since the depths of the pandemic, is still not back to “normal”; in Europe and the US, many people are quitting work and opting for early retirement—it is so severe that journalists are calling it the Big Quit. In most countries, there are far more job openings than people applying for work. Wage and labour costs, which were dead in the water for the past couple of decades as a result of China and technology, are rising sharply representing a, perhaps, unstoppable force in pushing prices higher across the board.

The fourth (or fifth) wave of the pandemic, which has surprised people in Europe and the US, could again create inflationary pressures, since the supply chain issues that remain difficult would be exacerbated in a few months.

Another major, and structural, inflationary force is the change in China’s policies, from growth at all costs—the “China price”, which was one of the prime forces keeping inflation subdued—to improving living standards domestically. As a result, wages and hence costs have been rising in China for a few years already, and continuing strong economic growth will continue to suck in commodities, which will keep global prices high, if not rising. Fuel costs remain stubbornly high partly because of a lack of investment and the recognition that the new green world will/may require lower amounts of fossil fuels. Again, food costs in different parts of the world are rising because of climate change.

And, finally, of course—although there is no finally—the gargantuan oceans of money sloshing around in markets show no sign of abating. The Fed has been making nervous noises but it has just started tinkering at the edges, hoping it doesn’t have to really crank things higher. The punch bowl is still pretty full even though the party—to judge from sky-high asset prices, particularly in the private and unlisted space—has been going on for a long time and still seems to get louder by the day.

There are now, of course, many people who are getting worried. In addition to all the “hard” evidence, they realise that since few people around today actively remember seriously high inflation, it wouldn’t take too much to create a real scare, which could then be self-fulfilling. With inflation having been under 4% since 1992, an inflation rate of even 8% could spook markets—and 8% isn’t very far from 6.18%.

The real concern is that, with the Fed already behind the curve, interest rates will likely have to rise higher and stay high longer than anyone expects. Back in August this year, I wrote, “…my sense is that markets are awaiting the start of Taper II and likely would be concerned that the Fed is falling behind the curve if it were delayed beyond the end of the year, in which case we could see equities fall out of bed.” This may explain the mayhem we are seeing now.

The currency market, of course, internalised this view, implying a stronger dollar, some time ago. Both the Euro and the yen are down more than 4% since July this year; indeed, both currencies are even lower [EUR 7.5%; JPY 11%] as compared to the start of this year. While there could be some correction here, it looks like a stronger dollar will be the flavour of (at least) early 2022.

The author is CEO, Mecklai Financial
http://www.mecklai.com

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