Inflation for the United States is “officially” around 2.9%. This is down significantly from the peak of over 9% in June 2022.
In June of 2022 I wrote, “I would not be surprised to see inflation peak at around the current 8.5% level and begin rolling over in the latter part of the year.”
It turns out that was, in fact, the exact peak for inflation in this cycle.
However, inflation has remained stubbornly resilient over the last year hovering between 2.9 to 3.7%.
Inflation Over the Past 10 Years
Recall, the Fed’s targeted inflation rate is 2%, and, yet, Federal Reserve Chairman Jerome Powell has stated it’s time for the Federal Reserve to start cutting interest rates.
To summarize… the stock market is near all-time highs, home prices are near all-time highs, the annual inflation rate is above the Fed’s 2% target, and the Fed is about to start cutting interest rates. Meanwhile, Chairman Powell, on multiple occasions, has been adamant that the Fed would not reverse course until inflation got down to their targeted 2%.
The Fed is becoming concerned about softening labor data and weakness in other economic data they monitor.
We’ve recently seen CEOs of numerous companies, particularly those in cyclical industries, expressing concerns on earnings calls about the financial health of their customers. Savings have been exhausted and households are racking up record credit card debt to make ends meet. In other words, the consumer is tapped out.
A Brief History Lesson
The last time the Fed began easing after a significant tightening cycle (pre-COVID era) was in 2007.
From around June 2004 to June 2006 the Fed raised interest rates from 1.00% to 5.25% to cool the housing bubble (a bubble they created by being too easy for too long).
Rates stayed there for little over a year until the Fed started cutting again in September 2007 to combat the bursting of the housing bubble, a slowing economy, and rising unemployment rate (sound familiar?).
At the Fed’s September 2007 meeting they cut by 50 basis points pushing the targeted Fed Funds Rate down to 4.75%, which kicked off a fifteen-month rate-cutting campaign during the Great Financial Crisis.
The Fed continued to cut rates all the way through December 2008 until the Fed Funds Rate fell to about 0.00%, which is where it stayed for seven years until the first 0.25% rate hike was enacted to get off the zero bound.
During the period of rate cuts from September 2007 through December 2008 the S&P 500 was about cut in half. In other words, contrary to popular belief, rate cuts do not “save” the market once aversion to risk takes hold.
Fed Funds Rate and the S&P 500
A Rock and A Hard Place
Real trouble for the Fed would arise if inflation were to stubbornly remain above the Fed’s 2% target while the labor market simultaneously softens and the economy slows / contracts.
This is otherwise known as “stagflation.” In that scenario, the Fed would be forced to make a choice between combatting inflation or propping up the economy / markets (think the 1970s into the early-1980s).
Inflation Misnomer
I’m hearing many folks attribute inflation to government deficit spending. And, yes, while significant persistent government deficits are a serious problem that must be addressed, it is not the reason for the sharp significant inflation we’ve experienced recently.
What is more impactful for inflation is HOW the government is funding those deficits.
The government has two options for funding deficits: (1) borrow money already in circulation, and/or (2) “print” money.
Borrowing
If the government is borrowing money from the public to fund deficits than it’s utilizing money that’s already in circulation and simply reallocating / redistributing it.
Significant federal borrowing can impact inflation by impairing our nation’s long-term productivity as the government siphons money from productive sectors thereby impacting supply of goods and increasing cost of production over the long-term. However, deficit spending generally won’t have the sort of immediate and severe impact on inflation that printing money has.
Money Printing
For example, if the Federal Reserve is creating trillions of dollars out of thin air and then lending that newly created money to the Federal government to fund deficit spending the Federal Reserve is directly increasing the money supply in the economy.
And, after all, we know an aggregate, sustained increase in the level of prices across the economy (i.e. inflation) is the result of (1) more money, or (2) fewer economic goods available, or (3) some combination of both more money and fewer economic goods.
This is why inflation after COVID was so strong and predictable. The Federal Reserve created and injected trillions of dollars into the economy while economic production was simultaneously shut down around the world (i.e. more money chasing far fewer goods).
So, no, deficit spending in itself does not lead to immediate, severe inflation unless it is funded by the Federal Reserve via newly created money. Significant, persistent deficit spending is a problem that absolutely needs to be addressed but not necessarily for the reasons commonly given. It’s important to clarify this because we cannot fix problems if we don’t even know the root cause of those problems.
