June 6 2022 Update: Inflation and the Federal Reserve

Inflation is when you pay fifteen dollars for a ten-dollar haircut you used to get for five dollars when you had hair – Sam Ewing

Recently U.S. Treasury Secretary Janet Yellen admitted she had failed to anticipate how long high inflation would plague American consumers. "I think I was wrong then about the path that inflation would take," Yellen said, when asked about comments from 2021 that inflation posed only a "small risk." It is refreshing when someone in government actually admits they were wrong. In Ms. Yellen’s defense, no one saw the resurgence of Covid via the Omicron variant, Russia’s invasion of Ukraine, and the continued bottleneck of the supply chain which was exasperated by the Chinese manufacturing shutdown due to their zero Covid policy. These forces came together at the same time causing an epic surge in global inflation.

Inflation continues to remain uncomfortably high and if this elevated pressure on prices continues for much longer the Federal Reserve may need to move interest rates higher than they would like which may push the U.S. into a recession. President Biden said in an op-ed in the Wall Street Journal that “fighting inflation is the Fed’s job” and he reaffirmed he would not interfere with the central bank's independence during this critical time.

In addition to raising interest rates, the Federal Reserve will begin shrinking the size of its $8.9 trillion balance sheet. During the pandemic, the Federal Reserve purchased a massive amount of financial assets, mostly government bonds and agencies to keep liquidity in the system and keep interest rates low. Now the Fed will start the process of letting these securities roll off its balance sheet without being repurchased, which is called Quantitative Tightening. The last time the Fed unwound its balance sheet was in 2018 which caused heightened volatility in the markets. Perhaps the Fed learned something from this experience, however the combination of raising interest rates and Quantitative Tightening will most likely result in more volatility over the short-term.

Why is this important? If the Fed gets it wrong and the combination of rising rates and Quantitative Tightening slows down the economy too quickly it would be difficult to avoid a recession. The stock market may have already put in its low for the cycle if a recession is to be avoided, however, if we do end up in a recession the stock market most likely will eclipse its lows. We hope inflation moderates soon, which would make the Fed’s job much easier. We continue to believe that well balanced, diversified portfolios should provide a degree of protection against volatility. At some point we may add to stock positions in some of our portfolios, especially if we see a sharp decline in stock prices. For now, we are monitoring the situation, reviewing portfolios, and rebalancing if necessary.

In the meantime, enjoy your summer and always feel welcome to call or email us with any questions or concerns.

The Bond&Devick Team