The Fed’s Problematic Situation

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Ryan A. Hughes
March 13, 2022
The Feds Impossible Situation

Before Russia invaded Ukraine (hard to believe it was only three weeks ago), the Fed’s job was straightforward, albeit not easy. The Fed was expected to raise rates ~7-9 times this year to combat our high inflation rate. 

Russia’s invasion complicates this task immensely. Higher energy and food prices, along with uncertain geopolitical events, force the Fed to attempt to combat inflation without pushing the world’s largest economy into a recession. So much has happened over the past few weeks that it has drastically changed the investing/capital/economic landscape. 

The Invasion Changes Everything

Before the Russian invasion, there were signs that auto prices were slowing, and supply chains were loosening. However, the invasion has changed all of this. Commodity prices have gone through the roof and may continue to climb this year.

Commodity Prices
Dow Jones Commodity Index | Source: spglobal.com

The Fed’s actions depend on the outcome of the Russian invasion. Nobody knows how this conflict will end, but we can all agree that there isn’t going to be a great outcome. According to Raoul Pal, ex-Goldman Sachs hedge fund boss, there are three possible outcomes. This is a very fluid situation with an infinite number of factors to consider. It is impossible to place a probability on each of these scenarios as it is impossible to know how to weigh each factor. Nonetheless, Pal’s three scenarios provide an excellent framework.

  • Best Case Scenario: Israel is able to negotiate a ceasefire between Russia and Ukraine. Ukraine will likely be split into two – Western Ukraine will remain independent while Russia will control eastern Ukraine. This lower-probability scenario will end with Western sanctions easing over time, though this will still result in a food crisis and a global recession.
  • Most Likely Scenario: Ukraine doesn’t negotiate or surrender. It will result in a brutal and bloody conflict where Russia will ultimately take Ukraine. Russia will install a puppet government. Western sanctions will remain, and NATO will amass weapons on the borders.
  • Worst Case Scenario: After Russia takes Ukraine, Russia will turn its attention to Poland as they have sent weapons, ammo, drones, and humanitarian aid to Ukraine. As Poland is a NATO country, the war will transform into an all-out war between NATO and Russia. This is a lower-probability scenario, but who knows. Let’s pray that this scenario does not occur.

Inflation

Inflation was already a big problem before this conflict started. COVID caused supply chain constraints and high unemployment. The government responded with an unprecedented $7T spending spree. M2, the measurement of money supply, has increased by 41% since February 2020 (as of Jan 2022). 

Fredgraph 4

As I have said before, “inflation is caused by a more rapid increase in the quantity of money than the quantity of goods or services produced during the same time period.” 

In other words, if we print money at a greater rate than what our economy can produce, the result will be higher levels of inflation. This has been true throughout history, and it continues to be true today. 

With the west sanctioning Russia and with Ukraine currently fighting for their homeland, energy (primarily Russian oil) and food shortages (wheat from both Russia and Ukraine) are putting even more upward pressure on inflation. 

The current inflation rate (as of February 2022) is 7.9%, the highest in four decades. Energy prices surged 26% over the past year. In my neighborhood, gas prices are over $6/gallon. These price increases can be devastating for the average American, especially lower-income Americans. In my opinion, the risk of a 2022 recession has increased drastically over the past few weeks.

The Fed’s Impossible Task

One would like to believe that Jerome Powell and the others at the Federal Reserve understand all of this. The Fed will have a challenging time achieving its two mandates: maximum employment and price stability. 

On the one hand, inflation levels are out of control. The Fed can combat this by raising rates and slowing the rate of M2. On the other hand, these rapid price increases threaten most Americans. If the Fed is too aggressive with its interest rate policy, it will certainly push the U.S. economy into a recession. 

We all would like to know how far the Fed is willing to go to combat inflation. Is Jerome Powell more like Paul Volcker, the Fed chairman in the early 1980s that hiked rates aggressively to finally slow inflation but also pushed the U.S. economy into a recession? Or is he more like Arthur Burns, Fed Chairman in the 1970s who did not raise rates nearly enough to tame inflation? Time will tell. 

Nonetheless, the Fed is set to hike rates by 0.25% for the first time since 2018. This week, what the Fed conveys to the rest of the world will be paramount. 

We had one unprecedented scenario with COVID, and now we have the prospect of WWIII to also contend with. I believe that the Fed will have to back off its plans to raise rates so much this year. Raising rates when the treasury yield curve is almost flat (currently a 0.25% spread between the 2-10 yr!) is a perilous move. 

Fredgraph 1 1

Combine all of this with frothy stocks, bonds, housing, and crypto prices, and you begin to see the problem here. 

I do not envy Jerome Powell at all. No matter what he does, it will be the wrong move. If he raises too much or doesn’t raise enough, he will be crucified by politicians and the average American alike. That’s what happens when you are too late to raise rates, and gas prices are $6/gallon.

Portfolio Allocation

It is a lot easier said than done when it comes to protecting your portfolio against all of these concerns. There is no perfect investment that offers protection from these numerous possible outcomes. Nobody knows how this will end, so nobody knows which asset classes offer the best upside. It is best to spread your bets accordingly. 

We have positioned our portfolios to profit if inflation continues to escalate, if geopolitical concerns continue to spiral out of control, if the Fed is too aggressive with its interest rate policy, and if the Fed decides to back off. We believe that it is wise not to make too big of a bet either way. This is not the environment to become too greedy, but instead, be cautious. 

If there is anything we can do to assist, please do not hesitate to reach out. 

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