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.