Inflation, Risk, Reward, and the Transfer Mechanism Effect
Good news. Inflation is slowing…slowly. Will slowly turn into too slowly? The data-dependent stock market has the answer. Probably by November. Could it be that people holding low fixed-rate mortgages, strong post-pandemic consumer balance sheets and low unemployment are pushing back against the Fed’s strategy to use the cost of capital to slow inflation?
June retail sales data were marginally softer than the previous month. The core rate, however, after removing gasoline, autos and building materials, was up six tenths of a percent.
Meanwhile, there is no doubt consumer spending is being pressured by (1) the disinflationary forces of the cost of capital and (2) the reduction of money circulating in the economy. This is called QT or quantitative tightening, and both are causing mortgage rates, auto loans and credit card debt to reduce consumer discretionary spending habits. So, QT and the cost of consumer debt is disinflationary.
Debt centers the mind of the individual or institution. It causes spendthrifts and corporate strategists to reassess spending strategies. Corporate decision makers must reassess the cost of future projects. Often such project no longer pencil out. Welcome to the way the Fed thinks about the cost of capital as the transfer mechanism to slow inflation.
No one really knows how high the cost of capital must go to slow inflation to the Fed’s target of two percent. The Fed believes that 2% inflation is the sweet spot for U.S. economic health. But why?
When inflation is too low, it can lead to deflation, which is a decrease in prices. Deflation can be harmful to the economy because it can lead to businesses and consumers delaying purchases, which can slow economic growth. When inflation is too high, it can lead to people’s purchasing power decreasing. This can make it difficult for people to afford necessities, and it can also lead to social unrest. A 2% inflation rate is generally considered to be a good balance between these two extremes. It allows prices to rise gradually over time, which helps to keep the economy growing.
So, a 2% inflation rate will generally be the best target for the Fed, even as the economy is constantly changing, and the Fed may need to adjust its target inflation rate in the future. However, for the time being, a 2% inflation rate is a good target for the Fed to aim for economic equilibrium.
In reality, the U.S. economy is rarely in perfect equilibrium. There are always external influences (governmental interventions, shutdowns, Russia, war, China, ESG, global warming) that can disrupt the balance, such as changes in technology (AI), government policy (Inflation Reduction Act-A tax increase), or consumer preferences (to stay in their homes). However, in theory an economy is in a state of equilibrium when the economic forces of supply and demand are balanced. In the absence of external influences, the values of economic variables will not change.
Just now the stock market is performing nicely. The NASDAQ, the S&P 500 and the Dow Jones Industrial Average Indices are all drifting upward toward their respective resistance levels. Volatility as measured by the CBOE Volatility Index (VIX) is low. Volatility has declined some 45% from one year ago. A higher VIX indicates that investors expect more volatility in the S&P 500, and a lower VIX indicates that investors expect less volatility.
Therefore, investors are more confident. But why? Are they more confident because COVID is over? Or is the Fed’s initial success against inflation the beginning of a new bull market? Is the low unemployment rate encouraging the markets? Is knowledge that hedge funds were on the wrong side of the risk trade now causing the pain trade to develop? So, is FOMO (fear of missing out) reflating market values? Does enthusiasm for the future of work using artificial intelligence software bring new money into this market? Do higher yields on money market accounts and savings vehicles lift consumer confidence and spending?
June data just released show the core rate of retail sales is still well above two percent, and this is data that comes after Fed officials are expected to raise rates to a 22-year high by the end of this month. Clearly the path to lower inflation comes by way of an efficient transfer mechanism. So, where the data show investors should be concerned about the transfer mechanism, the market shows certainty. Where the data show the Fed hasn’t completed the job of lowering inflation to 2%, the market looks out six months and believes by January of 2024 the task at hand by the Fed will be complete.
Summary July 2023
Social and Economic Concerns: Themes from July 2023
Inflation. Racism. The Multi-Trillion-Dollar Federal Debt. Consumer Spending. Oncoming Commercial Real Estate Collapse. Bank Crisis. Upcoming Tax Increases. Ukraine War. Dueling Tariffs. Slowing China. Low Birth Rates. Cyberattacks. Slowing Europe. Taiwan. Iranian Oil Tankers. So-Called Social Justice. Climate Change, Domestic Counterintelligence. Middle East Instability. Racism to fight Racism. Gap between Rich and Poor. Recession. Disease. Work and the Digital Age. AI. Education. Societal Polarization. The Cost of Living. Unchecked Immigration. Ideological Tribalism. Government Shutdowns. Science as Political Pressure. Free Speech. Social Media. The Loss of Objective Journalism.
I have added social and political issues in this summary of concerns because such issues can mitigate economic growth.
The Stock Market Response:
No problem. Monetary policy as an inefficient transfer mechanism is a good thing.
Sincerely,
Vaughn L. Woods, CFP, MBA
Vaughn Woods Financial Group, Inc.
2226 Avenida De La Playa
La Jolla, CA 92037
858-454-6900
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter are those of Vaughn Woods and Vaughn Woods Financial Group and may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0289.
Zerohedge
The New York Times
National Retail Federation
Bankrate
Forbes
The Wall Street Journal