“Inflation is just like alcoholism. In both cases, when you start drinking, or start printing too much money, the good effects come first and the bad effects come later. That’s why, in both cases there is a strong temptation to over do it. When it comes to the cure, it’s the other way around. When you stop drinking or when you stop printing money, the bad effects come first and the good effects come later. That’s why it is so hard to persist with the cure.” – Milton Friedman
In what can only be described as a nasty hangover, the markets of 2022 have been comparable to a hangover after the Covid induced money-printing party. The Federal Reserve poured the drinks in order to prevent a financial crisis due to the Covid pandemic, and now they are the ones telling us it’s time to sober up and recover from the hangover they caused. My last several market updates were focused primarily on the macro conditions driving the market. Primarily Federal Reserve policy as it pertains to money supply and interest rates. Right now, I believe it is imperative to have a firm grasp on monetary policy as it has become one of the primary drivers of the stock market and even the prices everyday people see in their day to day lives. Analyzing sectors for relative strength and finding individual stocks that we think are most suitable for investment is our job but it must be done through looking at the greater macro picture. The Fed continues to be outwardly hawkish with their words and many Federal Reserve board members continue to call for more interest rate increases and reductions of the balance sheet until inflation is lowered. In this letter I will continue my analysis of what is happening at the Federal Reserve, the Federal Government and how I see this all playing out.
Federal Reserve Policy and Inflation
Most people generally accept inflation to be prices going up or more money chasing fewer goods and services. But why does that happen? To put it simply, inflation is an increase in the supply of money and credit. The money that we use is “created” by the Federal Reserve. Since the 2008 financial crisis, the Fed has engaged in several rounds of quantitative easing. That's when it prints money and uses it to buy Treasury securities from banks. That increases the reserves of those banks. Inflation technically begins the moment money-printing takes place because it increases the supply of money. The Fed prints dollars with a computer stroke, and it increases the supply of credit by buying Treasury bonds from banks for cash, thus increasing bank reserves.
While printing money and lending it to banks increases the money supply, it doesn’t start to cause inflation until the banks lend it out to consumers. You can't spend bank reserves at the grocery store. Instead, bankers must be willing to lend more, and consumers must borrow and spend more to put the new money to work. A single dollar of newly minted reserves can be multiplied by a factor of 10 by being lent, spent, deposited, and then lent again from bank to bank.
The Federal Reserve money printing can be tracked by looking at the total assets owned by the Federal Reserve. The Fed’s assets consist almost entirely of treasury debt, mortgage-backed securities, and agency securities (basically Fannie Mae and Freddie Mac securities). The assets owned by the Federal Reserve have risen rapidly over the last 15 years after going from around $1 trillion to over $2 trillion in the great financial crisis. They continued to increase during the 2010’s through multiple rounds of quantitative easing. Then in 2020 we saw the balance of assets go from $4 trillion to over $9 trillion today. Pretty remarkable and not at all sustainable, look at the chart below.
While the Federal Reserve is buying all of these assets, the only way for this newly created money to cause rising prices is for banks to lend the money out and for governments to spend the money. The biggest spender of money and the primer driver of rising prices is the Federal Government. Government is able to seemingly spend unlimited amounts of money because the US Treasury is able to sell securities to the Federal Reserve for “money” that is created with a stroke of the keyboard. Over the last two and half years or so the total debt of the United States Government has risen from approximately $23 Trillion to over $30 Trillion today and is rising exponentially. I like the website www.usdebtclock.org to track a lot of this data. It is as interesting as it is terrifying.
This $7 trillion of new debt that is being racked up has already been spent or is about to be spent. The result is today’s 8.5% year over year inflation. This is real inflation and it is directly caused by the government printing a lot of new money and spending it. Consumers are increasing their spending in order to get ahead of inflation. By purchasing items now before they get more expensive, demand has risen creating a self-fulfilling loop of ever more inflation. It is going to take time for this new money to make it’s way through the system. There are signs that is slowing down as last month we had 0% inflation on a month over month basis.
Inflation Reduction Act
Congress, in a fight to stem the political downfalls of inflation recently passed the Inflation Reduction Act. The irony here is that in order to afford the spending programs in the bill, the government will need to borrow more money. In other words, the government will borrow and spend money to reduce inflation… which is the exact cause of inflation!! Inflation cannot be lowered by the government spending more money and the effects of this bill will most likely be inflationary. The only way government can reduce inflation is to reduce spending. It should be noted that the bill greatly increases the level of funding for the Internal Revenue Service, more audits and tax increases will be deflationary as consumers will have to pay more taxes and audits are costly. According to the Wharton School in Pennsylvania, the bill will have no meaningful impact on inflation.[i] I do not have any political opinion on the bill, all I can say is that is has nothing to do with lowering inflation and the name is insulting to our intelligence.
Recession? Like inflation, the definition of a recession is now political. The White House caused some controversy by saying the long-standing definition of a recession, two consecutive quarters of negative
inflation adjusted GDP, wasn’t true. I don’t think it particularly matters, but many of my clients and friends are worried about the prospects of a recession and many want to know how bad will it get and for how long. We did get 2 negative quarters of GDP and I guess technically speaking, that did used to mean recession[i]. However, the type of recession we have now is one primarily caused by inflation and that is much different than the types of recessions that have played out in recent memory. It may seem weird that we have recession and inflation together. Typically, inflation is caused by an overheated economy with too many good economic indicators. With this recession, inflation was caused primarily by $7 Trillion in new debt. Therefore, we may be looking at stagflation, the combination of inflation and recession.
The Federal Reserve and the US Government are trying to create a “soft landing” by slowly and methodically raising interest rates. The chart above shows interest rate policy over the last 40 years. Each time the Fed raises rates, they do so less than the previous cycle. I predict the trend will continue and in time the Fed will be forced to cut interest rates again. Historically, recessions have forced the Fed to lower rates but now that we don’t know what a recession is, who knows. If the Fed is able to lower inflation down to 2% in the coming months, that may be enough for them to pause or even reverse course. The debt load is becoming unsustainable and without a drastic cut to government spending, interest payments on the national debt will become politically difficult. The Fed is certainly stuck with a difficult decision, keep raising rates and cause a recession or lower them and allow inflation to stay elevated. Interest rate changes have wide macro implications. The financial media may compare them to a light switch, but in reality, it is like turning on and off a nuclear reactor.
At the end of the day, it won’t be the Federal Reserve Balance sheet, the Federal Funds Rate, or a bill passed by Congress that kills inflation. It will be a consumer that is tapped out and that can no longer afford to spend as much as they used to. Americans are saving at the lowest rate since 2009 when we were in the depths of a recession and credit card debt is rising rapidly. The cost of living has increased so much that consumer behavior is rapidly changing, resulting in slowing demand. While wages are up from 2019 levels, inflation has driven costs even higher. This has resulted in an explosion in credit card account openings, usage, and debt. While that may create the near-term optics of a healthy consumer. In the long term, the dynamic will destroy disposable income at a faster rate. Because servicing credit cards typically comes at a high cost due to interest rates. That means more money to keep households in good standing and less to spend on wants and needs. The result will be a further slowdown in economic output, bringing it back to pre-pandemic levels of consumption. The drop in demand will ease inflation growth going forward. And that, in turn, will support the Federal Reserve slowing or even pausing interest-rate hikes going forward.
Ironically, that should act as a long-term tailwind for the S&P 500.
After a brutal first half of the year, the market has enjoyed a nice rally here in the last 6 weeks or so. This has given all of us some relief. The macro-economic environment has made it hard to hold stocks and even harder to get a good night’s sleep. Despite the sticky inflation and out of control spending, there is always opportunity and a bull market somewhere. We are also still in a “risk on” environment. Despite the drawdown in all 3 indexes and the popping of the Covid stocks bubble. US stocks and commodities are still the place to be.
As you can see, US equities recently passed cash to enter second place on a relative strength basis. Commodities are still number 1, even though many have come down significantly from recent highs. Within the US stock market, value is still the place to be as growth names have largely struggled in a higher interest rate environment. Non-cyclical names, utilities, energy, and financials are all doing well. This is primarily due to the nature of these sectors having many value type stocks that pay dividends.
I don’t think we are going to be rocketing back to all-time highs in the market anytime soon, but in time it will happen. In the meantime, we need to be careful, keep a close eye on the names we own and work to navigate through these crazy times.
Summer is coming to an end and many of you have kids going back to school. Fall can be a great time to review your portfolio and financial plan. Please feel free to give us a call or schedule a meeting. We appreciate your trust and confidence and look forward to hearing from you.
Bruce Carlson, CFP®
Carlson Asset Management
 August 12, 2022 SENATE-PASSED INFLATION REDUCTION ACT: ESTIMATES OF BUDGETARY AND MACROECONOMIC EFFECTS Penn Wharton University of Pennsylvania
After 2 Consecutive Quarters of Negative Economic Growth, Is America in a Recession?
Most Americans believe so.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results.