Is the Fed losing control of inflation?
Abraham George Market Musings
On Friday, we received the last major inflation reading for the month of January (core PCE), and the markets did not respond well. Although inflation had cooled off throughout the fourth quarter of last year, it has once again raised its head in the first month of this year.
So, how should we deal with this situation? The most crucial aspect to understand about inflation is how the authorities perceive it.
Let us first take a look at the damage this has done to the overall technical picture of the major index - the S&P 500. Since the release of the CPI data on Feb 14th, the markets have been trending down. With yesterday's release, the markets have traded down to the downward-sloping trend line that described the bear market of last year. However, it also traded into the 200-day moving average, which acts as a dynamic trend line but bounced off that. Former resistance has become support now.
But the most important consideration is how the Fed is reacting to it. We are not hearing the reactionary tough talk from the Fed that we had last year. The Fed is now much more in control of the situation than before.
Jamie Dimon, the CEO of the largest bank in the US, has recently made some significant observations. With his extensive knowledge of consumer and business behavior and a seat with the Fed Chairman and White House economic advisors as a member of the “President's working group on Financial Markets,” he has a unique perspective on the matter.
He stated that the consumer is still strong, the balance sheets are in good shape, and "they are spending more than pre-COVID." He alluded to an ugly recession back in October of last year but has since changed his position. According to him, the economy is doing very well, and there has been a sea change in economic expectations. We are going through a transformation of a low inflation, low growth environment to a government spending-fueled growth in higher inflation that will bring a normalization of interest rates. Dimon added further and said the Fed "lost control" of inflation for a bit.
However, I do not believe that the Fed is going to change its position from what has already been communicated due to this latest inflation report. So far, we have not heard any reactionary tough talk from the Fed this time. Two voting Fed Presidents and the CEO of the largest bank in the US all think that interest rates can go up more, but nothing different from what has already been communicated.
Furthermore, the Fed needs inflation, but under their control, to run a hotter economy. Back in September 2020, the Fed Chairman made an official policy change in the way they evaluate their two percent inflation target. He stated that since inflation had been too low for too long, he would let inflation run hot to bring it back to a 2% average over time. This is now playing out.
If we take the average over the past 15 years (post-GFC), inflation remains below the Fed's two percent target. The government has fired a lot of fiscal bullets in the last fifteen years, resulting in the debt ballooning to an all-time high.
While this is not an ideal situation, the absolute value of the government debt does not mean much if the economy has also risen subsequently. The debt relative to the size of the economy is what matters. We need really strong nominal growth to inflate the debt away, but while growth is picking up, it is not happening fast enough to chip away at the debt.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office, and a hedge fund.