Inflation, the Federal Reserve Board,
and the Markets
September 29, 2022
Historians often write about “linkages,” tying together significant social and economic forces occurring on a global scale. One example is the trade linkages that helped to create and expand Great Britain’s 19th century empire.
In this report, The Mather Group, LLC (TMG) offers its perspectives on the linkages found between our current inflationary pressures, ongoing initiatives by the Federal Reserve Board (Fed) to combat them, recent equity and credit market volatility, and TMG’s response in its management of client portfolios.
For many citizens, the recent surge in and current level of inflation surpasses what they have ever experienced, given that inflation is more pronounced than it has been during the last 40 years. Prior to the onslaught of the COVID pandemic in March 2020, the greater fear among financial and political leaders was that the U.S. economy was entering a period of deflation, i.e., negative inflation rates, as occurred during the Great Depression.
However, with COVID-specific spending programs totaling $5.0 trillion, the federal government injected significant funds to stabilize individuals and households ($1.8 trillion), businesses ($1.7 trillion), state and local governments ($745 billion), healthcare facilities and programs ($482 billion), and various other stakeholders ($288 billion) as well.
As a result of these and other spending programs, the federal deficit has now risen by $5.8 trillion since March 2020, to a total of $31 trillion. The Fed contributed to these stimulus initiatives too by dropping its Fed Funds rate, i.e., the rate at which banks borrow funds from other banks, to 0.05% in April 2020 from 1.58% just one month earlier.
Might these significant spending programs and interest-rate cuts have contributed to our current inflationary environment? Let’s use the graphic shown below to explore this potential outcome. In April 2020, the Consumer Price Index (CPI) had fallen to an annual rate of 0.36%. With massive layoffs, multiple business closures, and strict isolation rules, it is not difficult to understand the origins of such a spiraling savings rate. However, just one month after the beginning of these COVID stimulus spending programs, the household savings rate, i.e., percent of disposable income saved each month, had risen to 33.8%, its highest level since May 1975.
It is also not difficult to understand that, once consumers began spending their excess savings, pent-up demand for limited goods and services would reverse falling CPI levels. Supply chain constraints, declining labor force participation rates, early retirements, and several other factors all contributed to inflationary forces that fueled the CPI’s rise to 8.3% by August 2022.
However, as these inflationary factors begin to stabilize, it appears that so-called “peak” inflation may be in decline. For example, the appetite for further federal stimulus spending has been waning significantly. The Fed has also reversed several of its earlier and strongly stimulative policy initiatives.
One result, as shown in the graphic below, is that consumers’ inflation expectation for the next 12 months, as measured by the University of Michigan, peaked in March 2022 at a 5.4% annual rate. It has since fallen to 4.6%, a level last reached in September 2021. It should be noted that this level is well below that of the current CPI, and it continues to trend downward. Of course, energy (7.5% of measured CPI) and shelter (31.4%) prices contribute strongly to the monthly CPI level, and recent price volatility has been—and may continue to be—significant.
The Fed also had a major role in sparking these last two years of accelerating inflation. First, the U.S. Treasury funded the several trillion-dollar COVID stimulus spending bills through the continued issuance of Treasury bonds, i.e., debt financing. The Fed stepped in to buy these and other government-backed mortgage bonds, raising its balance sheet from $4.2 in March 2020 to $8.9 trillion today, a 114% increase.
Second, through its so-called “quantitative easing” (QE) policy, the Fed increased the U.S. money supply, as measured by its monetary base, from $3.4 trillion in February 2020, to $6.4 trillion in December 2021, an 86% increase. With QE ending that month, the Fed has now shrunk its monetary base to $5.5 trillion, a 14% reduction. According to monetary economic theory, as posited by Milton Friedman, a significant decrease in the monetary base often results in reduced economic activity, a strategy that the Fed is actively pursuing to tamp down inflation.
Pivoting from labeling the initial jump in inflation as “transitory” in April 2021, the Fed has now declared its strategy to be that of throttling inflation back to its former 2% target. This includes a monthly decrease of $95 billion in its combined Treasury and mortgage bond holdings. The repayment of these bonds by their issuers will result in a further reduction of the Fed’s monetary base. It is uncertain as to when the Fed will stop its bond roll off, but it is estimated by Wells Fargo that a $1.5 trillion decrease would be equivalent to a 1.0% increase in the Fed Funds rate.
Finally, the Fed has begun to make aggressive changes in its Fed Funds rate, raising it by 3.0% during the last six months from near zero at the start of 2022. Unfortunately, the Fed Funds rate does not move in isolation to the credit markets.
For example, according to the Freddie Mac, the government-backed mortgage agency, 30-year fixed-rate mortgages were priced at 2.90% in September 2021. A year later, that rate has moved upward to 6.29%. One result is that existing home sales in August 2022 were at an annualized rate of just 4.8 million homes, having fallen from the 6.5 million level reached in January 2022, a decrease of 26%. As shelter prices are a significant proportion of the CPI, this sudden sales decrease supports the Fed’s inflation-fighting strategy.
Despite the Fed’s assertions that it intends to reduce current inflation levels significantly in the near term, it is important to note that there is no historic playbook for the Fed to follow in pursuing its parallel goal of avoiding a recession—a so-called “soft landing” for the economy.
For example, during the last inflationary episode in 1980, then Fed Chairman Paul Volcker eventually had to raise the Fed Funds rate to 22.0%, with unemployment eventually rising to 10.8%. After inflation peaked at 9.8% in 1981, the Fed Funds rate fell back to 3.4% when Volcker stepped down in 1987.
The Fed’s strategy does have some welcome news for U.S. consumers, however. More specifically, as shown in the graphic below, its recent interest-rate hikes have strengthened the international value of the U.S. dollar significantly. The Fed’s broad-weighted index of the U.S. dollar, i.e., valued against our 25 largest trading partners and the Eurozone countries, has risen 6.6% since the pandemic began. The rise has made imports to the U.S. less expensive. This is very good news for our inflationary outlook, whether for imports of commodities, e.g., plastics and organic chemicals, or finished goods, e.g., autos.
It is not so good news, however, for the Euro currency (down 10.4% against the dollar since the pandemic began) and the UK pound (down 10.0% against the dollar as well). Not so good too because both the UK and the 27 countries in the Eurozone are all net importers of energy, which is priced internationally in dollars.
The geopolitical crisis in Eastern Europe has only heightened the fragility—and pricing—of these countries’ energy imports. In contrast, the U.S. has been energy independent since April 2020, according to the U.S. Energy Information Administration. So, the Fed has that factor in its favor as it works to lower inflation in the U.S. economy.
Both inflationary pressures and the Fed’s current strategy have heightened recent volatility levels in the U.S. equity and credit markets. One measure of market volatility is the Chicago Board Options Exchange (CBOE) Volatility Index (VIX). The VIX measures the expected volatility of S&P 500 Index futures over the next 30 days and is often labeled as the markets “fear gauge.” As shown in the graphic below, the VIX rose to historic levels at the start of the pandemic (its index value was 74.6). However, its recent level of 27.1, while still somewhat high, represents a 64% fall from its pandemic spike.
Equity markets, as measured by the performance of the Standard & Poor’s 500 Index (SPX), have responded recently to the Fed’s aggressive strategy. However, while the SPX has fallen 20.6% from its December 2021 high, it remains a quite significant 57.9% above the low it reached upon the pandemic’s onset. So, for investors who remained fully invested during the uncertainty of the pandemic’s U.S. arrival in early 2020, recent market volatility has not eroded a sizable proportion of their subsequent market returns.
Credit markets, as represented by annual yields on both the 5- and 10-year U.S. Treasury bonds shown in the graphic below, have also reflected the recent upward trend in the Fed Funds rate. Of course, Treasury bonds, when held to maturity, should recover any temporary price erosion in their principal value. In addition, interest payments from these bonds can be reinvested in more recently issued, higher-yielding bonds to enhance overall bond portfolio returns in the future. New funds entering client portfolios can also be invested in such higher-yielding bonds.
Looking toward future market performance, it would appear that the uncertainty of near-term corporate profits may be another driver of recent market volatility. However, given the number of uncontrollable macroeconomic factors discussed in the inflation segment of this report, TMG does not believe that market pundits can offer effective, actionable insights for long-term investors. Instead, our view is that clients who continue adhering to their financial plan will maintain a stronger pathway through this inflationary period.
In summary, TMG believes there are three important points to share with respect to recent inflationary pressures. First, several of the factors driving recent inflation appear to be either stabilizing or declining. The strength of the U.S. dollar, combined with U.S. energy independence, have shielded our economy from many of the inflationary drivers ravaging other countries. Geopolitical risks remain, of course, but not on our soil.
Second, the Fed has adopted a more aggressive strategy toward reversing current inflationary trends. This strategy may continue to disrupt both equity and credit markets in the near-term, but it appears necessary to avoid a repeat of the 1980s inflationary spiral that drove unemployment to levels not seen since the Great Depression.
Third, clients who remained fully invested at the outset of the pandemic still retain sizeable gains in their equity portfolios, while those with recurring bond interest and principal payments continue to have those funds reinvested at higher yields. This reinvestment strategy increases overall portfolio cashflow.
TMG continues to employ its risk management tools in response to this inflationary trend. These include constructing and rebalancing diversified investment portfolios, and applying accelerated tax strategies, such as tax-loss harvesting, to help increase future after-tax income.
Your trusted TMG advisor is ready to respond to any questions or concerns you might have and to help ensure that your financial plan remains both timely and actionable. Please reach out to your advisor for guidance at any time.
Data Sources: Bloomberg; Bureau of Economic Analysis; Bureau of Labor Statistics; Chicago Board Options Exchange; Federal Reserve Bank of St. Louis; Federal Reserve Board; Freddie Mac; Goldman Sachs; Reuters; Standard & Poor’s; New York Times; University of Michigan; US Treasury; Wall Street Journal; Wells Fargo Investment Institute
The Mather Group, LLC (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, see the firm’s Form ADV on file with the SEC at www.adviserinfo.sec.gov, or on the firm’s website at www.themathergroup.com. The opinions expressed, and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on TMG’s research and professional experience and are expressed as of the publishing date of this communication. All return figures and charts shown are for illustrative purposes only. TMG makes no warranty or representation, express or implied, nor does TMG accept any liability, with respect to the information and data set forth herein. TMG specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice. Investing involves some level of risk. Past performance does not guarantee future results.
An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Please feel free to contact us for additional information on any indices mentioned.
Indexes
• CBOE Volatility Index (VIX): The VIX is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index (SPX). Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility. Volatility, or how fast prices change, is often seen as a way to gauge market sentiment, and in particular the degree of fear among market participants.
• Consumer Price Index (CPI): The CPI is a measure calculated monthly by the Bureau of Labor Statistics that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
• Standard & Poor's (S&P) 500: A stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.
