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How Concerned Should I Be About Inflation?

How Concerned Should I Be About Inflation?

November 22, 2022

Every time we go to the grocery store, we are seeing higher prices on the same items we purchased the week before. Many products have even been repackaged with smaller quantities or cheaper packaging materials to lower costs to offset rising inflation.

High inflation is often in the news and was talked about frequently by candidates in the recent national election. Chairman of the Federal Reserve, Jerome Powell, has stated that it is a top priority of the Federal Reserve to reduce inflation.

Let’s explore the issues caused by high inflation and you can consider how concerned should you be about inflation.

In this blog, we will discuss:

  • The Current State of U.S. Inflation
  • U.S. Federal Reserve Increasing Interest Rates
  • Reducing the U.S. Federal Reserve Balance Sheet
  • The Dangers of High Inflation
  • Will the U.S. Federal Reserve Cause a Recession?
  • How Might a Recession Impact Me?

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The Current State of U.S. Inflation

On November 10, 2022, the Bureau of Labor Statistics released the Consumer Price Index for October 2022.

Consumer Price Index for October 2022.
Source:  Bureau of Labor Statistics1

Over the last 12 months, the “All Items” index increased by 7.7%, before seasonal adjustment. Economists and analysts were expecting 7.9%, which led to a significant rally in the stock market.

Large hedge funds that were short the market were forced to purchase an estimated $225 billion in stocks in two trading sessions to cover their short positions in just two trading sessions3. Investors also became more hopeful that the U.S. Federal Reserve would slow the pace of interest rate hikes. The good news is that inflation for all items has been coming down for the past 4 months.

U.S. Federal Reserve Interest Rates

On November 2, Federal Reserve Chairman Jerome Powell, announced at his press conference that the Fed Funds Rate would be raised by 0.75% to 3.75%, while a 0.75% interest rate hike was expected by analysts.

At the start of the press conference, Powell used language that made investors think that they may raise interest rates less than expected or keep them high for less time than expected.

But later in the press conference, Powell made the following comments:

  • “We need to bring our policy stance down to a level that’s sufficiently restrictive to bring inflation down to our 2 percent objective over the medium term.”
  • “… as I mentioned, incoming data between meetings, both a strong labor market report but particularly the CPI report, do suggest to me that we may ultimately move to higher levels than we thought at the time of the September meeting.”
  • “Our message should be, what I’m trying to do is make sure that our message is clear, which is that we think we have a way to go, we have some group to cover with interest rates before we get to, before we get to that level of interest rates that we think is sufficiently restrictive.”

Concluding with these remarks during Powell’s press conference sent the stock market down several percent that day.

Our view is that with inflation rates at 7.7%, there is a significant amount of work still to be done by the Federal Reserve to get interest rates down to their target of 2%. The big question is how much pain will be inflicted on the economy to get the inflation rates back down to the target.

The pandemic of the past few years has pushed a large amount of stimulus money into the economy and has resulted in a surplus of jobs and a shortage of workers. A big unknown is whether these factors will make it more difficult for the Federal Reserve to reduce interest rates over the next year.

Reducing the U.S. Federal Reserve Balance Sheet

In addition to raising the Federal Funds interest rate, another important tool that is used by the Federal Reserve to stimulate, or slow the U.S. economy, is the buying and selling of bonds.

Quantitative easing is when the Fed increases the size of their balance sheet by buying bonds (because this puts money into the economy). Quantitative tightening is when the Fed decreases the size of their balance sheet by letting bonds expire and not replacing them with new bonds.

Since the beginning of 2022, the Federal Reserve has been using Quantitative tightening to reduce the size of their balance sheet.

Size of the Federal Reserve Balance Sheet (Trillions of Dollars)

Size of the Federal Reserve Balance Sheet (Trillions of Dollars)
Source:  Federal Reserve Website4

So far in 2022, the size of the U.S. Federal Reserve balance sheet has been reduced from about $9T to about $8.6B. The Federal Reserve actions of raising interest rates and reducing the size of their balance sheet are very powerful tools to slow down the U.S. economy, with the goal of reducing inflation.

The Dangers of High Inflation

Economists usually consider periods of high inflation to be more dangerous than a recession because it can range from a few years to many years to get high inflation back down to the Fed’s target level of 2%. The U.S. experienced high inflation during the 1970’s and 1980’s and the Fed had to raise interest rates to very high levels to drive down inflation. The Federal Reserve does not want to let high inflation get entrenched in the U.S. economy, thereby making it take longer to reduce it to their 2 percent target.

When inflation gets high, many parts of the economy become affected. The Social Security Administration announced that it will increase Social Security benefits by 8.7% in 2023. This is the highest increase in about 40 years. The Trustees of the Social Security Trust Fund project say that the Trust Fund will run out of money in 20352. The concern now is that a large increase in Social Security benefits could cause the trust fund to run out of money even sooner.

High inflation can set in motion a spiral of increasing prices that sees the price of goods increase, then labor salaries increase when workers demand larger pay increases to cover the cost of higher goods, which increases the labor to make the goods and then the inflation spiral continues upward.

This upward inflation spiral is slowed when demand for goods slows, causing retail to reduce prices to sell their goods. This reduction in demand can be accompanied by a recession. If the Federal Reserve can slow inflation, they can more easily bring the economy out of recession by lowering interest rates. But the Federal Reserve can’t lower interest rates if inflation is still too high because it may drive inflation back up. So, the U.S. Federal Reserve is more likely to continue driving down inflation and demand and accept a recession and rising unemployment as a necessary step toward lower inflation.

Will the U.S. Federal Reserve Cause a Recession?

As the U.S. Federal Reserve continues to raise interest rates, economists and market analysts are moving from the question of “will there be a recession?” to “how deep will the recession be?”  Estimates range from a shallow recession to a deep recession.

Our view is the economy is already slowing and by the end of 2023, it will likely be clear that there was a recession in 2023, but it is very difficult to predict how severe the recession will be.

There are factors pointing to a mild recession which include:

  • Lots of money in the economy from all the pandemic stimulus
  • Very strong labor market with currently more job openings than available workers in some parts of the U.S.
  • U.S. consumer spending has remained strong

There are also factors that could result in a more severe recession which include:

  • A very fast hike in interest rates from 0 to possibly over 4% in one year
  • Interest rates on 30-year mortgages over 7% causing a slowdown in the housing market
  • High Energy prices
  • Potential recession in Europe caused by the war in Ukraine
  • Continued economic disruption in China due to their Zero-COVID policy

But only after the recession is over will we be able to assess the economic damage caused by the recession.

How Might a Recession Impact Me?

A recession can have an impact on many parts of the economy. The U.S. economy has been very strong the past couple of years, perhaps too strong, and a pullback in the economy could provide some opportunities. Here are a few examples:

Homes – home prices have skyrocketed the past few years around the country. The interest rate on 30-year mortgages has gone above 7%, making homes less affordable and driving down home prices. In a few years it may be possible to purchase a home at a lower price than it is today.

Home Remodeling – the strong economy the past few years made it difficult to get parts to remodel a home. It has been difficult to get contractors to do the work and prices for the work have been skyrocketing. A recession may make it easier to find quality contractors and the pricing for remodeling may start to come down.

New and Used Cars – new car prices have increased significantly with inflation. New cars have been in short supply the past few years due to part shortages from supply chain issues. This has also contributed to driving up the prices of used cars. A recession may reduce the demand for cars, making it easier to find the car you want, and force auto makers to offer incentives to reduce the prices.

Travel – strong travel demand after the pandemic has driven up prices for cruises, airline tickets and hotels. A softening in the economy could drive down some prices for travel.

We think that over the next 1-2 years there will be some opportunities for better prices on goods and services than we have seen the past few years.

Where Do We Go From Here?

We are monitoring the stock market daily as we see large moves up and down, driven by the latest news headlines. We think there are still some challenging times ahead if the U.S. economy is headed for a recession. Some of the largest Silicon Valley tech companies have already announced large layoffs. The stock market has been in a bear market in 2022 and we are being somewhat defensive in our portfolio allocations for client accounts.

We have started buying short-term U.S. Treasuries for some of our most risk-adverse clients, and we still do not own any bond funds for our clients. We think it is getting close to the time to start buying bond funds for all our clients and we could start purchasing them before year end.

We have been in the financial business through economic booms and recessions, through bull markets and bear markets. This experience has been extremely valuable to help us guide our clients through this challenging market, and we know from experience, that these challenging markets also present opportunities that we look for every day.  

If you have questions on how the topics in this article could impact your portfolio, give your Wealth Manager a call.

Financial Journey Partners

Financial Journey Partners - Partners in Your Financial Journey®

Our Financial Journey Partners office is based in San Jose, California. We have clients that live in many states across the country. If you have questions about your investments or financial situation, call us to schedule time to talk about your specific situation.

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1 US Department of Labor – Consumer Price Index

2 Congressional Research Service – Social Security: What Would Happen If the Trust Funds Ran Out

3 Advisor Perspectives – Quants Forced to Shed $225 Billion of Short Bets in Big Squeeze

4 Federal Reserve – Credit and Liquidity Programs and the Balance Sheet