How long is inflation here?

The markets were on absolute fire.

Crypto was booming, growing from $300 billion to over $3 trillion in market cap.

Stocks cranked up to new all time highs. Unemployment was extremely low. Companies were reporting very strong earnings quarter after quarter.

On the surface, everything looked great. But there was this growing problem, largely due to the mad money printing of the Federal Reserve.

Inflation.

With inflation hitting 40-year highs, the Federal Reserve made an announcement that interest rates were going to rise, and that news sent the markets into a free fall.

Why? Let me explain.

When interest rates go up, companies don’t remain as profitable because their costs to borrow money increase. Most publicly traded companies borrow money. If companies are less profitable, then their stock price drops.

I know that it’s a lot more enjoyable to read about fantastic developments and future growth stories. That’s my preference too. Talking about inflation and what the Fed is or isn’t going to do is not exciting for anyone. Nothing would make me happier than to see a return to healthier conditions and to write a blog focused on a great high-growth company with fantastic technology.

But right now, in this current environment, institutional capital does not think growth stocks are a good bet. It has largely stepped aside to avoid the volatility. And it all comes down to the monetary policy being pursued by the government, the Fed, and other central banks.

What’s Happening Now?

Federal Reserve Chairman Jerome Powell has made clear that the Fed will continue to hike rates, regardless of the toll it takes on the economy. For evidence, we can look at Powell’s comments from the Jackson Hole Symposium:

“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions”.

To translate that, Powell is saying that rate hikes will likely cause a recession (below trend growth) and lead to higher unemployment rates (softening of the labor market). And the Fed is still moving forward with its rate hikes, because they are convinced it’s the only way to get inflation under control.

Now, I want to be clear.

Just because easy money is over (at least for now), it doesn’t mean a stock market crash is imminent. Nor does it mean that every stock is about to plummet. We don’t need to run for the hills.

Time in the market always trumps timing the market. But that also doesn’t mean we need to catch a falling knife.

It does mean that we should be prepared for a lot of volatility over the next 6 – 12 months. And it means we need to take action to protect our portfolios.

The bull market of the past 13 and a half years which sent the S&P 500 up 226% and the Nasdaq up 443% was helped by historically low interest rates. Low interest rates make money and leverage easily accessible. They drive capital into projects with growth potential, both public and private, and that means equities and venture capital.

And while rates were at historic lows, the Fed expanded its balance sheet to increase liquidity in the markets.

In response to the 2008 financial crisis, the Fed began purchasing assets like U.S. Treasuries and mortgage-backed securities. When we look at the Fed’s “balance sheet” we’re seeing the amount of assets the Fed is holding on its books. It’s a pretty remarkable chart.

Prior to the financial crisis, the Fed was holding less than a unit trillion in assets on its balance sheet. Today, that number is around USD 9 trillion.

If we zoom into 2018, we can see the Fed attempted to “roll off” its balance sheet. Around the same time, the Fed was also in the process of raising rates. The result was a market crash that forced the Fed to change course.

Not only has the Fed not pivoted yet, they doubled down on their destructive interest rate hike policy. Powell said as much in his Jackson Hole speech that I shared above.

And then, after the FOMC meeting on September 21, 2022, Powell said:

“We have to get inflation behind us. I wish there were a painless way to do that. There isn’t. So, what we need to do is get rates up to the point where we’re putting meaningful downward pressure on inflation”.

So, Powell’s saying he will continue to raise rates and he doesn’t care about the consequences. He knows it’s going to bring pain at our expense. He’s okay with the stock market going lower, people losing jobs, and retirement accounts being destroyed.. He’s even okay with the whole country spiraling into a recession.

We have a rough stretch ahead of us.

And here’s the part that very few realize:

Today’s inflation is not a problem central bankers can fix.

Two Types of Inflation

Inflation comes in two forms. It is reflected by a direct devaluation in the dollar. Basically, it is a problem the Fed can fix. As painful as they were at the time, the Volcker rate hikes of the late 1970’s and early 1980’s finally brought inflation under control and set the stage for a multi-decade bull market in equities.

But there are so many other problems that cause inflation, that the Fed can’t fix.

Supply and demand imbalances? Inflation.

Bad fiscal and economic policies? Inflation.

Government prints and spends trillions of dollars that it doesn’t have, thus creating massive deficits? Inflation.

Economic policies are implemented that directly result in higher prices for the things that we need in our daily lives? INFLATION.

The Fed’s Policies Hit Financial Markets First

There’s a limit to the impact that the Fed’s interest rate policy has on the real economy. The real economy is what you and I participate in every day when we engage in commerce. Lower interest rates don’t cause people to quit their jobs or change how consumers use healthcare services. And they certainly don’t cause supply chain disruptions.

Rising interest rates do however impact large purchase decisions that require financing like cars or houses.

The largest impacts of changes in the Fed’s policy are first felt in the financial markets. As mentioned before, low rates and balance sheet expansion are the two of the most common “levers” the Fed can pull.

But these actions never impacted inflation much. We have had record low interest rates and balance sheet expansion since 2009. But as we can see in this chart, despite the low interest rates, inflation stayed between 2% - 4% during this time:

If easy monetary policies directly caused prices in the real economy to rise, we would have seen record high inflation since 2010. But it wasn’t until the middle of 2021 that inflation picked up.

So, what changed this time?

Why This Time is Different

The government’s economic and fiscal policies from the past two years are the reason for today’s inflation. Never before have we had such a clear example of the impact of these policies on the economy and inflation.

For over a year, governments around the world shut down factories and production lines in an attempt to stop the spread of COVID-19. Ports were shut down and shipping lanes were clogged. The backlogs to get items through customs were enormous.

The supply of necessities like food, gas, and new homes shrank. We couldn’t even get enough basic semiconductors manufactured to produce household appliances and vehicles. We’ve had shortages of everything from toilet paper (Why, oh why John Q. Public, did you need to buy it all!!) to baby formula, from ground beef to carbon dioxide for carbonated beverages.

At the same time as supply was curtailed, governments handed out massive amounts of stimulus checks and unemployment benefits, to the tune of multiple trillions. Locked in their homes with nothing else to do — and flush with “free” money — consumers did what we’d expect.

They began spending.

Online spending in the United States increased by more than 50% between 2019 and 2021. That’s not a big increase - that’s horrifically MASSIVE.

To state the obvious, when supply drops and demand increases, prices have only one way to go. And after consumers bought up all the available goods, prices did just that - they went up, and fast.

The Fed can’t fix these problems. The Fed can’t improve supply chains, or get people back into the labor force. The Fed does not build new semiconductor manufacturing facilities. The central bank can’t issue more leases for natural gas and oil drilling. Put simply, the Fed can’t force the world to produce more goods to meet demand and bring down prices.

This is why the inflation today is fundamentally different from the inflation of the 1970’s, the last time inflation was this high.

In the 1970s, inflation was brought on by a crisis of confidence in the dollar. In 1971, President Nixon removed the direct convertibility of the dollar into gold. The dollar was no longer backed by anything besides the good faith and credit of the U.S. government.

Other countries and investors began to sell off dollars to buy gold or hold their own currency. This caused a devaluation of the dollar, which led to higher prices for goods (inflation). That’s a problem related to the relative strength of the currency, a problem the Fed can — and did — influence.

This dollar devaluation sent the dollar down 50% from peak to trough. And the consumer price index (CPI) rose 150% from 1970 until Volcker cracked inflation in 1982.

But it didn’t have to be that way. Jerome Powell and other Fed officials believe the Fed of the early 70’s made one drastic mistake: They lowered rates too early. And that led to a resurgence of inflation at the end of that decade.

It took Paul Volcker taking over as Fed chair in 1979 to bring about some sort of stability. And he hiked the Fed Fund rate above 20%. Not like I remember; I was born in 1978. Any of you purchased a home in the 1980’s? This is why your mortgage rate was likely close to 20%.

Can you imagine a 20% mortgage rate? Interest rates are still, despite the recent raises, at historical lows. We have clearly been spoiled and forgot about what it’s like to not be spoiled.

Today, Chair Powell sees lowering interest rates too soon to be the biggest possible mistake the Fed could make. He believes premature easing would result in a 70’s-style return of inflation.

Fed Policy May Backfire

Our problem today is not a crisis of confidence in the dollar. In fact, the dollar is stronger than every other major currency this year. And as we covered last month, it has soared since the beginning of 2021.

Our problems today stem from the policies I’ve been writing about. That is the cause of the inflation that we have right now. And the Fed cannot fix this. In fact, the central bank could actually make inflation worse.

If we wanted to get inflation down, we’d make sure companies had access to the capital they needed to secure and increase supply. That added production would push down prices and lower the CPI.

But with raising interest rates, it will be more difficult for these companies to access the funds needed to expand production. And this will likely exacerbate the supply chain problems.

To take a simple example, let’s look at the housing market. Even with the current weakness in real estate, home prices are still near record highs. The reality is that the United States is faced with a monumental housing shortage. This is especially true for affordable housing.

If new home construction had continued at the previous pace before 2000, there would be 5.5 million more units of housing than currently exist.

The solution to lower housing prices is straightforward: Increase supply, that is, build more houses. But homebuilders are not incentivized to do that now. With rising rates, the cost to finance new building projects has increased. And with rising mortgage rates, new buyers won’t be lining up to purchase these homes.

This is one reason why I believed the Fed would have reversed course by now. Tightening could make inflation worse.

The Fed, and the government for that matter, is taking a huge gamble right now. They are betting their destruction of demand (by raising interest rates) will outpace their destruction of production capacity.

I don’t think it’ll pay off. We should expect higher interest rates for longer than I previously thought. This will continue to keep capital out of the equity markets, especially to “risk on” assets like tech stocks and crypto.

So What Should We Do?

There are two ways to look at this.

One is, we continue to wait out the Fed and don’t enter the markets until we have a clearer picture of interest rate policy. Once the Fed signals they will decrease interest rates, the markets will absolutely explode upwards. We can enter the market at that time and ride the wave up. Simply accumulate cash and sit on it, and attempt to time the market.

Or, we look at this as an incredible accumulation period. We need to go in with the expectation that it could be 6 to 12 months before the interest rate policy becomes favorable.

This window of a depressed market will give us more time to accumulate more cash flow, and then take that cash and buy assets that are massively discounted. We will position ourselves for the next bull run.

The problem with option 1 is that it’s incredibly difficult to time the markets.

The problem with option 2 is that we may be catching a falling knife; we buy the current dip and then it dips that much more.

What am I doing? A combination of both.

I’m cautious about deploying more capital into the markets I’m being patient, waiting for dips, waiting for more cash to flow in, and then I’m jumping on quality companies that have a great 5-year outlook.

Plus, I’m holding some cash back in the event the market drops further. In addition, I like the “X” bonds strategy quite a bit. It’s a way to guarantee a small return with zero risk and position yourself that if the markets do melt up, you’ll be able to cash in.

I explain exactly what they are and give you a free pick in last week’s newsletter (I pay a LOT for this research, trust me).

Heads We Win. Tails We Win Even More.

At the end of the day, I don’t care that much what the financial markets do. I’ve got a well diversified portfolio of private businesses, real estate syndication, cash flowing rental properties, crypto, whole life insurance, stocks, and private equity.

The stock market is going to do what it always does, move up and down with its occasional violent swings. If the market drops 50%, then my net worth drops maybe 5%.

I never wanted my financial future to entirely be in something I can’t control and provides no real consistency.

I don’t think that you want your entire financial plan to be at the whims of the market. Take the steps to learn about different asset classes, and insulate yourself from 25% market drops.

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