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  • Writer's pictureLavina Nagar

Inflation - What's Fed got to do with it?

Few weeks ago, I asked my clients what is on their minds. I never anticipated the number of responses, and more than the number, how deep, thoughtful, and though provoking the responses were.

As one can guess, inflation topped the list of responses, followed by the question “when will this end?”, asked in many forms and different words. I have written on inflation in earlier blogs. Causes of current inflation are well known now – fiscal stimulus during covid, supply chain issues resulting from the pandemic, labor shortage, Ukraine invasion. Today I will focus on how inflations end. For this, let us turn to history.

Last time U.S. had witnessed significant inflation was in 1970s and early 1980s. The tool that Fed uses to manage inflation is interest rates. Why? As the interest rates go up, it becomes more expensive to borrow money (think of mortgage rates, auto loans). This forces consumers to spend less on other goods. When spending declines, demand falls and, eventually it leads to decline in prices of goods and services.

In 1970s, the Fed kept interest rates below the inflation rate. And that did not help. The entire decade saw very high inflation. What eventually helped was when the Fed under Paul Volcker, who headed the Federal Reserve between 1979 and 1987, raised the interest rates above the rate of inflation. It broke the back of inflation. But the price was steep, as the U.S. fell into a deep recession.

Today, the Fed is turning to what it believes is its tried-and-tested anti-inflation playbook. Powell’s Fed is well aware of the mistakes that helped lead to the prolonged period of rising prices in the 1970s. And the Fed do not want to repeat the same mistake. It wants to avoid the stop and go attack on the wage/price spiral of the 1970s, which failed to quell inflation and led to a harsh policy response from Volcker’s Fed. The thinking goes, longer inflation persists, more difficult it is to put the inflation genie back in the bottle. At the end of August, Powell vigorously reiterated the Fed’s commitment to bringing inflation back down. In a brief speech that lasted less than nine minutes, Powell called the Fed’s goal of price stability its “overarching focus right now”. He added that softer economic growth will “bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.” Powell’s use of the word ‘pain’ is unusual for a Fed chief. In no uncertain terms, he wanted to communicate that the Fed is resolute in its fight and will do what’s needed to force inflation back to the Fed’s target. However, the Fed is hoping to employ lessons learned in the 1970s without a steep recession.

Currently, inflation is high, but it is not as embedded in the economy as it was in the 1970s, and part of it is also driven by supply issues. So far, the medicine that is needed is unlikely to be as harsh as during the early Volcker years. In addition, the job market is very strong. The high number of job openings leaves some wiggle room that might help prevent a recession or anything more than a mild recession.

This all sounds good in theory – to subdue inflation with a soft landing, i.e., by avoiding a recession. But the reality can be different than the theory. If central banks respond to a weakening economy and stop hiking early, there is a chance inflation may rebound. If it does, even higher rates may be needed to quell inflation. This would be very similar to the scenario that played out in the 1970s and early 1980s. Alternatively, the Fed can hike rates until the interest rates are above inflation. But that is a long way to go given the current inflation rate and the Fed fund rate. If the Fed persevere, the economy and stocks may face another volatile year like 2022. Volcker's aggressive action on inflation came only after a decade of painfully high inflation in the U.S. A similar policy in today’s world after one year of high inflation would face intense political and popular backlash, especially if recession pressures deepen and job losses mount.

Inflation will come down. Question is speed and how much growth will the Fed have to cut and how much pain it will have inflict to achieve this. Economic and market forecasting is a very inexact science. Simply put, there are too many unknown variables. So, if we do not have an answer then what is the purpose of all this analysis? Because it helps to understand what is causing the chaos so we can go back and review our long-term strategy and ensure if it still stands ground or we need to do something different. I believe considering the complex global environment and factors that are causing this inflation in the U.S. and worldwide, placing bets on any outcome is a gamble. Investing is a marathon and not a sprint. Make sure your portfolio is positioned to serve and support you for the long run.

On a completely different note – it is gut-wrenching to see what hurricane Ian has done to wide swath of communities. My request to all of you who live in California, Oregon, and Washington states – please do not forget that we live in earthquake country. Please stay prepared with emergency supplies. And please consider earthquake insurance.

Lavina Nagar, CFP(R) is the president and founder of Maya Advisors, Inc., a financial planning and investment firm in Palo Alto, California.

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