20 Jul 2018 Inflation, the Fed, and Markets

President Trump weighed in yesterday on one of the last truly apolitical federal institutions; the Federal Reserve. He bemoaned the possibility that their recent interest rate increases might derail his attempts to improve economic growth to what he believes is closer to its true potential – 3% and higher.

However, the economists of the Federal Reserve believe that an economy picking up steam or one growing too fast will cause inflation to rise above their stated targets of 2% for inflation. The argument pits politics against policy as presidents win or lose on the strength of the economy during their watch and Fed Boards are legally mandated by Congress to keep prices stable.

Presidents have historically avoided criticizing the Fed for its moves, but this President seems laser-focused on the economy and sees rate hikes as overly cautious at this point. So, we thought this might be a good time to take a look at inflation, the Fed, the economy, and some of the complexities that make monetary (money) policy so complicated and mysterious.

Inflation, or rising prices, generally occurs when an economy begins to grow faster than its supply of labor, raw materials, capital, and other ingredients needed to produce goods and services causing instability in prices. In other words, supplies needed to meet an ever-increasing demand, become less available in delivery timing and quantity, driving up their prices.

When demand for employees rises faster than the supply of prospective workers, employers must pay more to meet their needs from a diminished pool of availability. To retain their existing workers in this dynamic, employers must also increase their pay. The same holds true for all other goods and services required by the company. When demand exceeds supply of anything or service, its price rises because of its scarcity.

Rising prices are not in and of themselves a bad thing. In fact, our economy has normalized about 2% as the right level of price increases or inflation to maintain stability in pricing. The problem occurs when fears that increasing prices begin to change the way people behave in their spending. When a person begins to believe that the necessities for living might cost considerably more in the future, he begins to hoard, placing further demands on an already scarce market for certain goods, driving up their prices further. A vicious cycle begins, and it can be difficult to stop.

Money in this country, and indeed in most, is known as fiat currency – created by decree and backed by the full faith and credit of that country. Because it is not backed by precious metals as it once was, it can be expanded for political reasons in quantity well beyond the country’s gold or silver reserves, which are finite. The Fed was created (among other reasons) to police the nation’s money supply, and by necessity, must remain independent of political pressures bent on policies that might cause price instability.

In short, inflation happens where there is too much money chasing too few goods or services. The Fed and the President disagree as to what level of interest rates and money supply are appropriate in today’s faster-growing economy. The Fed believes conditions are ripe for increasing inflation, while the President believes the economy can grow at 3%, perhaps more, without inflationary pressures. He further believes that further increases in interest rates risks reversing the gains in economic growth.

Money is not created at the country’s four mints, as many might believe; they only print new bills to replace old ones. Money is created when banks lend to businesses and consumers through loans, mortgages, and credit cards. Without constraints, banks could and would conceivably continue to expand the money supply until the economy collapsed under the weight of hyperinflation created by too many dollars chasing too few goods and services.

In 1913, the Central Bank, known as the Federal Reserve was created to balance competing interests between private banks and populist desire for economic stability. Today, the Fed has a triple mandate to maximize employment, stabilize prices, and moderate long-term interest rates.

The Fed controls the money supply in this country with essentially three tools. The first is interest rates. The Fed has increased rates twice so far this year; in May and June. The Fed Funds Rate is the interest rate at which the government lends money to banks that in turn lend to customers. As banks’ cost of lending funds rises, they must increase the price of their loans to customers (interest rates) as well. When loan rates rise, people borrow less money and growth in the money supply begins to slow or it actually shrinks, spending in the form of consumption slows, and eventually inflation declines.

The second tool used by the Fed to slow inflation is that of increasing reserve requirements on the amount of money banks must keep on hand to cover withdrawals. As the Fed increases bank reserve requirements, banks must reduce their lending to consumers. Growth in the money supply is further reduced.

Finally, the third method used by the Fed is to directly or indirectly reduce the money supply through policies like increasing interest rates on Treasurys (known as coupon rates) making them more attractive to investors. Companies, the engines of the economy, are hit twice as their stocks become less attractive than higher rate bonds, and consumers are spending less and saving more. The economy slows as the money supply declines along with the demand for goods and services.

Another consequence of higher interest rates is a rising dollar. As the US economy is growing faster than the European economy, global investors are buying more dollars to invest in American companies. Also, as interest rates rise, global investors are buying more dollars to buy US Treasurys at higher rates than competing sovereign debt, held down by their central banks to stimulate economic growth in those countries.

But a stronger dollar increases imports and reduces exports as US-produced goods become more expensive than foreign-produced goods. Countries with cheaper currencies benefit as Americans buy more of their goods and services until their economies, currencies and interest rates rise, approaching a some neutral again. China, however does not play by the rules of global trade, manipulating their currency to keep it low, thus making their goods more attractively priced. They use the huge stockpile they’ve amassed of US dollars and US Treasurys in unbalanced trade to manipulate the value of their own currency.

The recent spate of American tariffs dampens the natural flow of trade in and out of the US that would normally be based pressures created by currency rates and prices because it adds a tax on top. The tax makes certain imported goods more expensive, despite the foreign prices being driven down by the stronger dollar. To the extent that tariffs are not replicated abroad, trade imbalances may be held in check, but trade has become much more complex for business and consumers. Only time will tell whether tariffs prove to be a successful tool in negotiating better trade agreements with Europe, Japan, and our North American neighbors. China is the big question mark, but as stated earlier, they have more to lose than the US does in a trade war by a considerable amount.

What Do Rising Rates Mean for Our Treasury Holdings?

Market forecasters are generally more confident in making their predictions about the movements of interest rates and the bond markets than they are about stock markets. That’s because the indicators of interest rate changes are generally preceded with indicators that come sooner and with greater accuracy than stock market indicators. The above paragraphs have focused on some of those indicators. But don’t be worried about their calls to get out of bonds. Their reasons for owning them are, generally speaking, tilted toward their investment value.

As you know we own Treasurys primarily for their insurance value against the constant threat of stock market volatility. When economic and stock market uncertainty become acute, investors seek out the promise of steady interest payments and the repayment of their original investment offered by US Treasury more than any other debt instrument and generally more often than gold, real estate or other alternative investments. As an insurance policy it is relatively inexpensive to own. The 7-10-year index we own, represented by IEF, has never been down more than 9% and never down for two consecutive 12-month periods. It currently yields 2.72% (SEC 30-day yield) and is down 1.9% for the year with Federal Reserve rate increases. The three and five year averages as of yesterday are 1% and 2% respectively, with the declines of this year.

Given that bonds trade on a much longer time horizon than do stocks, it is likely that the Fed’s expected interest rate increases are largely baked into current Treasury prices. At this point the insurance reasons for owning them to protect against volatility it greatly increased. While we are in no way suggesting stock market problems, the market is priced at the historical high end of its trading ranges and, therefore, more vulnerable to bad news. The Treasury market, on the other hand, should bounce nicely on any  bad news, keeping your carefully allocated portfolio far more stable than it might be with alternative risk measures.

If you have any interest in delving more deeply into the reasons we use Treasurys please consider a couple of past Briefs focused exclusively on the topic: The Case for Treasurys Even When Rates Rise and Why Do We Own US Treasurys and Why Do Ships Sink?  And not too long ago Ryan Smith posted a fascinating Brief on a study that showed that Treasury returns exceeded most stocks over longer periods of time in Turns out Most Stocks Fail to Outperform Treasury Bills. 

If you are uncertain your portfolio is designed to meet the rigors of volatile markets ahead, please give us a call.