Inflation Mismatch – September 2022

The US stock market was up 7-10% in July only to give up 4% in August with continued selling in early September.    

Under the leadership of Chairman Powell, the Federal Reserve has made it clear that it will do what is necessary to break the back of inflation by raising interest rates “forcefully” which may likely cause “pain” in the economy. These are the exact words used by Chairman Powell at a recent conference in Jackson Hole, WY at the end of August 2022.

Inflation is due to a mismatch between demand and supply whereby “price’ clears the market.

While the FED can reduce demand by increasing interest, it has no effect on the supply side of the inflation equation. The Federal Government “fiscal policy” has tools to affect both demand and supply. During the past two years the government increased spending dramatically adding more demand to the economy. Supply has been constrained during the past two and a half years due to several factors. Most notably, the pandemic caused many economies around the world to shut down. These supply chains are in the process of coming back online. China has been the most aggressive in shutting down production with its zero COVID policy.

In our opinion, US fiscal policy could constrain spending (demand) but has exhibited a reluctance to do so as illustrated by the many spending initiatives signed into law.

Supply side economic policy of easing regulation, especially in the energy sector, and tax policy to encourage investment would lead to additional supply. At the current time we do not see fiscal policy changing to help bring demand and supply into better balance. Therefore, it will be up to the Fed to increase interest rates to reduce demand and thereby inflation.

The US stock market headwinds of rising interest rates may remain until the first half of 2023 when we expect inflation to materially abate.

Commodity prices have declined since June 2022 suggesting the aggregate price level may have peaked. Once the calendar page 2023 turns, year-over-year inflation should decline. This backdrop may give the FED reason to curtail raising interest, and depending upon economic growth, it may begin easing interest rates if inflation is constrained.

We continue to believe the US stock market will recover from the current malaise by the second half of 2023 which is 12-18 months after consumer confident hit an historic low in June 2022.

Richard S. Lawrence, CFA / September 8, 2022

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