Peak Inflation?

“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.