This Byproduct of Federal Reserve Policy is Responsible for Low Headline Inflation – by Michael Carino, Greenwich Endeavors

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After experiencing high levels of inflation in the 1970’s,
government policy was determined to minimize future inflation related costs
that come from poor policies.
  This was a
difficult period when, after a prolonged period of loose and easy monetary
policy, headline inflation lead to double-digit interest cost.
  High inflation hamstrung politicians’
abilities to fund their agendas and instead distracted them with budget and
cost issues.
  Knowing that politicians
and the political landscape would lead to poor policies in the future, the US
government pursued policies that minimized the impact of actual inflation.

 

Determined to minimize these risks, the US changed the means
of calculating official government reported statistics on inflation and
highlighted these indices as the pertinent statistics to follow.  One of the changes was to recalculate the way
housing and shelter costs are calculated. 
This component of the inflation statistic represents almost half the
inflation basket.  The current
calculation minimizes inflation in this basket which often deviates to the down
side significantly from actual inflation seen in housing prices (currently occurring
again today).  They also quality adjust (hedonic
adjustments) and substitution adjust the inflation numbers which constantly
leads to a lower reported inflation bias. 
Yes, the true inflation costs that the public pay are much greater than
the reported statistics that have been running around 2% per year.  One needs to look no further than their health
care, education and housing expenses to know this is true.

The Federal Reserve, which was set up to be independent of
political interference now seems nothing more than a puppet for the
administration that appoints the Federal Reserve Chairman to office.  One of the goals of the Federal Reserve is to
keep the cost of government debt low.  A
prudent monetary policy should focus on a medium to long term horizon without
taking short term risks and shortcuts.  Instead,
due to pressures and political interference, the Fed pursues policies that lead
to instant gratification and least political fire.  The Fed manhandled bond yields to
historically low levels, brought rates to zero and added trillions of dollars
to the system.  I’m sure the significant
financial asset inflation from these Fed policies will lead to an
uncontrollable situation down the road and a future financial crisis (I’ll save
this topic for another article).  But in
the short run, Fed policy has put additional unhealthy downward pressure on
inflation.

The financial crisis of 2008 and banking regulations that
followed led to less availability of credit. 
As a result, as credit became available, low cost money was allocated
mainly to the largest firms.  Large firms
were perceived to have the least financial risk.  Additionally, these firms were perceived to
have the least political risks and potential career risk since may other
institutions were also lending to them.  I
agree that getting credit flowing into an economy that suffered a downturn is
necessary.  But instead of using these
funds productively, expanding and hiring new employees, these large firms used
this competitive advantage of credit and low rates to grab a bigger slice of
the pie and drive the smaller competition out of business.  This self-reinforcing feedback loop of large firms
offering goods and services at lower prices, funded by the ability to access
lower cost credit, placed temporary downward pressure on inflation.  But boy does it set the future up for a nasty
surprise.

After almost 10 years of misguided Fed policy giving this
unfair competitive advantage to large firms, the landscape is filled with a few
massive firms and few small firms that cannot compete.  This oligopolistic or monopolistic system that
was fostered by Fed policy now leaves us exposed to many risks. 

The next downturn will surely show these risks.  These large firms will have significantly deeper
layoffs and at a quicker pace than a collective of smaller firms.  With no competition, they will have no
incentive to lower prices and instead decide higher prices maximize shareholder
return and maintain profitability in a shrinking market.  Productivity and innovation will surely be
slower. 

Short run focused Federal Reserve policy has led to the
lowest yields ever with significant asset inflation (stocks, bonds and real estate)
to unhealthy levels.  These conditions disproportionally
assisted larger firms.  Unfortunately,
after 10 years of easy monetary policy, we have indulged in too much of a good
thing.  My fear is the next recession
will be met with large firms laying off employees at a pace and level never
before seen and inflation picking up instead of going lower.  This is known as stagflation.  The Fed will not be able to adjust monetary
policy to lower yields (or accumulate balance sheet) and may instead be forced
to raise rates to respond to inflation.  The
Fed may find if they don’t pursue prudent monetary policy during the next
downturn, inflation may turn into a hyperinflation cycle with a rapidly
depreciating dollar. 

This leaves fiscal policy to assist a depressed economy.  Fiscal policy takes time and starts with
voting in new politicians that can work together and agree on constructive
policies.  As we have recently seen in
Greece, political discontent can lead to a lost decade and is not a quick
solution.

Current Fed policy and government actions have steered the economy
through significant change with little understood and disruptive risks
percolating under the surface.  What may
appear only to be soft gentle winds could be sowing the seeds of the next
inflationary hurricane.  This will make
the next economic crisis difficult to respond to and can take years to restructure
the economy, hopefully for the better.  So
take a picture, we will miss these “Kodak moment” blissful conditions in the
future.

 

by Michael Carino, Greenwich Endeavors, 9/12/17

 

Michael Carino is the CEO of Greenwich Endeavors, a
financial service firm, and has been a fund manager and owner for more than 20
years.  He has positions that benefit
from a normalized bond market and higher yields.