What happens when almost 30 years go by with almost no need to tighten rate policy significantly due to inflation? Complacency. Couple that with a Fed Chair whose background has broken the chain of PhD Economists which went back to Allen Greenspan’s tenure starting in 1987, and you have a recipe for a botched inflation forecast and policy error.
The Fed has now been shamed into dropping the “transitory” moniker for the inflation we are seeing. As of the last Fed meeting, they have had to admit that the inflation we are seeing cannot be simply due to supply chain bottlenecks or pandemic related causes, and has gone on stronger and longer than the Fed anticipated.
The reason it matters that we don’t have an economist to oversee the Fed is that an experienced forward looking data wonk is not at the helm. The deep analysis of past Fed Chairs gave them unique insights into problems. Alan Greenspan was famous for his his esoteric data points, I heard early on in my career that he would look at boxing and packaging numbers as well as light truck sales as some of his favorite leading indicators for economic activity.
Ben Bernanke was an expert in The Great Depression and how the Fed handled it at the time. Deep study of The Depression and monetary policy at that time, in the tradition of Milton Friedman, helped Bernanke steer the Fed towards groundbreaking and unprecedented policy innovations during the financial crisis that helped avoid catastrophe. Make no bones about it that The Great Recession could have been much worse without Quantitative Easing or the Troubled Asset Relief (TARP) programs.
By the time Jerome Powell was appointed, it seems a sense of complacency had taken root at the Fed. The Fed is not immune to what is called anchoring bias: anchoring their expectations in what happened in the past and not updating their view based on new and pertinent information. This seems to be developing as not just the case for the Fed but the market in general. Many banks and experienced economists went along with the Fed’s transitory argument. Notable leaders who did not include Mohammed El Erian and Warren Buffet, who exclaimed earlier in the year that Berkshire was seeing significant inflation across all its businesses.
Yet the Fed in its response to the pandemic seems to be mimicking the response taken during the financial crisis, which was very different in nature. At that time, banks were essentially insolvent, and the Fed had to act as a lender of last resort to prop up many markets. With the pandemic, the Fed stepped in to prop up markets whether it needed them or not. This was to counter a forcible closing of businesses by the government for public safety. Rather than having the QE sit within the banks to repair their balance sheets, or target specific industries most affected, Fed purchases went across industries straight market participants, who used the funds to bid up other assets.
This time around, the Fed also seems to have assumed that when it slashed rates to zero, they would need to stay there for some time as they did after the 2008-2009 financial crisis. Yet even with rates at zero, the climb back from a banking crisis is often slow and arduous and rates needed to stay low longer after the crisis to help the economy recover. The snap back economy of the pandemic is a different animal. That the Fed didn’t seem to see this as a new type of challenge may lead investors to question its outlook and credibility, if they haven’t already.
Scaling Back
Market consensus and the Fed seem to think that repeating policy approaches of the recent past should guide its current policy when there is little justification for this. There is no reason that the Fed can’t raise rates and taper at the same time but some seem to think it will loose credibility if it does. They often invoke the “Taper Tantrum” of 2013 as justification for this. Fed governors should ignore this kind of talk. The most important credibility the Fed has is anchoring inflation expectations, not catering to stock market expectations.
Yet the Fed seems to be hyper tuned to the media and market opinions about stocks and ignores those which point to the capital destroying forces of inflation. This means it will likely follow a path of winding down tapering in its meeting over the next few days and leave rates alone until 2022. This is one reason many are predicting that inflation will stay with us for some time as these inflationary measures like QE persist.
Where and How to Invest
Inflation produces strange incentives and shifts money towards particular parts of the economy. It can act as a tax on the poor by eating wages away while the rich can hedge themselves by taking out debt and shifting to assets that benefit from inflation, like energy.
Before I go into what assets may help and where you may want to put new money, it helps to understand how some savvy people use both sides of their balance sheet to combat inflation.
Fixed Rate Debt – Many market participants, including myself, thought that QE would produce inflation when it was first implemented after the financial crisis. Pythias who expected inflation may have likely stocked up on a valuable tool for those looking to benefit from inflation: fixed rate debt.
The reason for this is that if you are paying a liability with a fixed rate over a long period and inflation exceeds that rate, then it’s making your debt cheaper to manage. The ideal situation is where you borrow to hold assets that appreciate with inflation and pay down the fixed rate debt with those proceeds, which has gotten cheaper due to inflation. My personal choice to satisfy these criteria was real estate. US mortgage rates hit record lows due to the massive QE the Fed was pumping into markets and home prices boomed. As inflation rises, the interest on my debt stays fixed for 30 years while I can raise rents in line with inflation on my tenants.
This isn’t a cut and dry approach though. Unexpected inflation should eventually cause the Fed to raise rates which will damper the economy and the housing market. Lack of demand and more expensive debt could put strains on the capacity of borrowers to purchase at lofty prices. This means that although the income from real estate may be hedged, the value of real estate may not be, which can cause problems if you are looking to sell property.
Bonds – Another area to avoid is bonds. We have been in almost a 40 year bull market for bonds which may be coming to an end. Valuations for bonds are sky high due to negative real rates but as inflation expectations begin to change, bond prices will also, and dramatically. We have already started to see some of the worst losses in treasuries since the early 80’s and I expect more to follow.
Oil – In any other time, energy and oil would act as a hedge and if you have been holding oil future contracts or an ETF that holds them like OIL, then you are up over 40% this year. Investors should remain cautious here however, although oil remains essential for the global economy, we are at the start of a fundamental shift in energy consumption and green sources of power are becoming preferred over fossil fuels. The inflation outlook is now uncertain and a drop in demand from rate hikes and a subsequent recession could dampen global demand for oil, chipping away at its utility as an inflation hedge. In this “stagflation” scenario, hedging with oil also may not be the pure play it’s backers claim it to be.
Foreign Stocks – I almost hesitate to call this one but it’s bears mentioning. The US is a bit of an outlier at the moment in terms of inflation and we shouldn’t lose sight of the fact that the largest and most aggressive stimulus has been on the US. Other countries such as New Zealand, Norway and Sweden stopped their QE programs months ago. Even if their firms don’t have the growth prospects that US firms do, on a simple valuation basis coupled with a likely increase in the value of foreign currency, foreign stocks will inevitably start to become more attractive to investors.
Whether emerging markets will be the winners in this case remains to be seen. Many emerging countries were battered much harder by the pandemic and took on large amounts of foreign currency debt which has left their governments susceptible to a fiscal crisis. These types of crises can quickly wipe out any gains to be had from commodity production or currency appreciation that many emerging countries experience when the dollar falls.
Overall
The one thing each of us can do to hedge inflation better than anything is to invest in ourselves for the long run. Being the best doctor, carpenter or teacher will often allow you to command a premium to the market price for your skills. We can’t help what the Fed does, but making sure you are equipped to do well in any type of economy by being great at what you do is a well travelled path to doing well. Keep this in mind when moving forward and get ready for a bumpy ride in markets in the next year as the Fed finds its footing.
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