Where’s the Fed Put?

The Fed’s dual mandate is to strive for maximum employment while maintaining price stability. But for the last four decades, there was no inflation risk. The effect of demographics on inflation is the subject of academic debates, but it’s clear that technology and globalization kept a lid on inflation.

From 2000 to today, prices for TVs, computers, and other electronics—mostly made in China—dropped by over 80%. Prices for transportable goods like clothing and toys dropped significantly as well.1 And in commodity markets, gains in productivity spurred supply. (T. Rowe Price’s research platform has been at the forefront of estimating the disinflationary impact of increased productivity on commodity prices. Think: the shale revolution.)

With no inflation risk in sight, every time we faced a growth shock, the Fed came to the rescue with rate cuts and asset purchases. To the extent there was inflation, it was in financial assets. Like a drug addict, the economy became dependent on stimulus. Every shock required a bigger dose to get the same “buzz.” The Fed’s balance sheet ballooned. It bought government debt. The country’s debt-to-GDP ratio climbed higher and higher.

The Fed lowered rates, we borrowed more. We put this feedback loop on “repeat.” Rates went to zero. We got trapped under a rate ceiling that went lower and lower. Rates couldn’t rise too much or the cost of rolling and servicing our debt would explode.

Those were the days. COVID changed the equation. We did what we had to do to prevent an economic depression. Central banks and governments deployed $24 trillion in global monetary and fiscal stimulus—a truly staggering amount, way, way above what we had ever seen, including in 2008–2009.2 Zero rates; trillions in asset purchases; and some unprecedented measures, such as generously enhanced unemployment benefits, loans to small businesses that could be forgiven, and over 400 million checks of $600–$1,400 directly into people’s pockets—essentially, dropping free money from the helicopter.

And we poured this stimulus on top of restricted supply. We created the ultimate recipe for inflation. Take that, secular disinflationary forces. Inflation was running high at the beginning of 2022. It was broadening. It wasn’t going to be transitory.

Then, Russia invaded Ukraine. A shock on a shock. The war added:

• sanctions, including in energy markets;?
• more shipping jams (Black Sea); and?
• an agricultural commodity supply squeeze.?

Oh, and the supply response in oil and gas markets disappointed. We realized that maybe the energy transition had been managed too aggressively, at least relative to the world’s energy needs (and geopolitical security needs).

Now, the Fed must pick a poison: inflation or recession. It looks like it will pick a recession. The Fed needs to fight inflation, even if it means pushing demand off the cliff and letting unemployment rise. Unfortunately, the Fed can’t pump oil, manufacture semiconductors, and solve shipping delays. The longer supply chains remain jammed, the more aggressive the Fed will need to be on the demand side.

Meanwhile, the cloudy and uncertain environment can quickly change. Stocks have priced in a lot of bad news. If you ask me to give you investment wisdom in an elevator, say between floors two and four, in a few seconds, I’ll say this: Stay invested and diversified. It sounds trite, but it’s more relevant than ever in the current market environment.

1 Source: BEA. Prices of electronic/durable goods have fallen 85% between 2000 and now. Detailed PCE price deflator for video, phonographic, and information processing equipment—BEA’s category for TVs, computers, and electronic consumer goods. Plasma screen TVs used to cost $10,000!

2 $11 trillion in QE (central bank B/S are $26 trillion now: source: Atlantic Council, QE Tracker) + $13 trillion in fiscal support (change in government debt from 2019 to 2021 as % of GDP * 2021 World GDP in U.S. dollars, source: IMF Fiscal Monitor) = $24 trillion in fiscal and monetary support.?

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