The Fed’s No-Win Dilemma

Earlier this week we talked about what to watch for when it comes to the Fed handling the current bout of inflation.

It’s not an enviable spot for Chairman Powell to be in.

The Fed can only talk a good game for so long. Eventually they’ll have to take some action on the “political” inflation that I mentioned in your last letter

And when they do it’s going to pose a SERIOUS threat to your wealth.

Let me explain…

The Fed’s Original Sin

The problem (maybe irony is a better word) where Jay Powell is concerned, is that the current situation is entirely of his own making. (Well, his and Janet Yellen… and Ben Bernanke…  and Alan Greenspan — 34 years of Fed Chairmen!) 

It dates all the way back to the late 1980s and it’s called the “Greenspan Put.”

In October of 1987 the stock market crashed, losing some 34% of its value. It gave up the majority of that value in just 5 days. And shook market confidence like nothing else in recent history had.

Alan Greenspan, then Chairman of the Fed, came to the rescue with what became known as the “Greenspan Put.”  In a nutshell, it was a monetary policy that offered investment banks access to easy money designed to “backstop” the markets. 

In other words, the Fed doled out a bunch of cheap cash investment banks could use to beef up their balance sheets and start buying stocks again.

Financial Armageddon was averted — and who could argue with that kind of success?

The Greenspan Put unofficially became a new tool in the Fed’s monetary tool box. (In reality it became the Fed’s new policy standard.)

It became the standard response to every apparent crisis faced by the markets.

It ramped up into high gear during the last two major crises in the market: the tech crash in 2000 and the housing bubble in 2008.  In every case the Fed rushed to the aid of the wounded investment banks to prop them, and the markets, up. 

Did it save the world? Maybe.

But it also created the ugly unintended consequences that we’re facing today.

But before we talk about that, let’s pause for a second and talk about this thing called inflation.

Inflation 101: The Three Types of Inflation

While you and I think of inflation in terms of higher prices at the store or gas pump, economists view the term a little differently.

When economists talk about inflation they mean inflating the monetary base — or the amount of money in the system. (Once upon a time, about 40 or so years ago, money supply was actually an important report where the markets were concerned.)

The amount of money in the system was typically regulated by the level of interest rates. Higher interest rates will drain money out of the system because investing your money for a higher return is more attractive than blowing it on that new Tesla.

So “monetary inflation” is one type of inflation.

But that inflation can also lead to the type of inflation that you and I and the folks on the news talk about…

That’s called CPI or price inflation.

More money in the system, chasing a fixed amount of goods eventually leads to those painful higher prices everyone recognizes.

A lot of folks call this kind of inflation a tax on the middle class or working poor. Because it takes more money out of your pocket to buy the same amount of stuff you bought just a year ago. It drains your wealth (and anything that does that basically is a tax). 

Finally there’s asset inflation. 

Unlike CPI inflation, this shows up when the prices of things usually considered financial — like stocks and homes and real estate — take off into the stratosphere. 

It’s also the result of too much money chasing too few goods, but in this case it usually results when the cost of capital, i.e. interest rates, is low (or basically free) like it is today. 

Free money? Let’s buy that house we can’t afford.

Asset inflation, unlike CPI inflation, makes us richer instead of poorer. (At least temporarily.)

So we’ve got monetary inflation, CPI inflation and asset inflation. 

There is one important thing you need to understand about how they relate to each other: 

It’s possible to have asset and/or CPI inflation without monetary inflation. (Other supply-side factors can cause prices to rise, although it’s usually transitory. Think of gas prices in the 1970s.)  But monetary inflation will almost always drive the other two.

Too Much of a Good Thing Ain’t Good

For the better part of the last 20 years, thanks to the Greenspan Put, that’s all the Fed has been doing — pumping money into the system. 

In the last two years alone — via quantitative easing measures like directly monetizing the Treasury’s debt — the Fed has increased the monetary base by trillions.

The problem with an endless stream of cheap (nearly free) capital is that eventually markets become addicted to it. You simply can’t take the punch bowl away mid-party. They need it, not only to recover from financial crises, but just to keep everyone’s 401(k)s afloat. 

And that’s what’s been happening since the last crisis bottom in 2009.  

But now, thanks to the pandemic, CPI inflation is on the rise and becoming a serious threat to the economy. The only way to slam the brakes on that is by raising rates. (And honestly, the effectiveness of that would be questionable because supply issues definitely are a factor this time.)

But on the other hand, raising rates takes all the cheap capital away from the market and threatens to reverse the asset inflation we’ve seen for so long — in other words, pop the bubble. 

The worst case end result would be CPI prices continuing to soar while asset prices collapse, a real dilemma for the Fed.

The sad part is that when the end does come, it’ll be the little guys who lose their savings while investment banks will be lining up to cash in more Greenspan Puts…

As an investor your goal should be to preserve your wealth. That means not getting it stolen at the grocery store, but also not losing it in a massive financial market collapse. 

Right now inflation and interest rates are the key to everything. We’ll be watching them…

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily