- Ref:: Perfiliev Financial Training
- Title:: The Fed Won’t Save Us From Stagflation
- Author:: Perfiliev Financial Training
- Year of publication:: 2022
- Category:: blog
Notes from reading
- How Fed can cause inflation
- How the growth / inflation relationship can break
- Current stagflation drivers
- Fed's failure to fix it.
If the demand is constant and in equilibrium with supply, prices are stable, and there is no inflation. There’s also no economic growth, which is a hard sell for politicians. They want things to go up.
- And the Fed can make that happen. The Fed can lower rates and perform their Quantitative Easing voodoo to stimulate the demand. Attracted by lower rates, consumers are more likely to buy flat-screen TVs and replace their 1-year old iPhones
- When demand rises, the supply side needs to keep up – companies increase production, hire more people, buy more raw materials, import goods from abroad etc.
If supply meets the demand, we are in a happy place. Both are increasing, so the economy is growing. And since they are in equilibrium, prices are stable, and there is no inflation. Good stuff!
- Politicians are happy and can take credit for delivering sustainable economic growth to their voters. The Fed also feels smug as they’ve nailed both sides of their dual mandate – price stability and employment
As the demand continues to grow, at some point supply will hit the maximum output capacity – the economy simply can’t produce and deliver enough stuff that consumers want to buy. There is now an imbalance between demand and supply.
- Prices rise, and you get the classic “demand-pull” inflation. Consumers notice that every trip to the grocery store is more expensive than before and ask for a pay rise. Higher wages lead to higher prices, and we get the inflation spiral
- This is bad
- While consumers are losing purchasing power, the politicians are losing votes (unacceptable). And that's when the Fed steps in to save the day! Fed Chairman will calmly talk about how the economy is strong, and the labour market is tight. They will act like they got everything under control, but in reality, they’re like, "oh my God, there's too much demand! Shut it down! Shut it down!!! Steady… Steady! Oops! Fuck. Overdid it again."
By raising rates and tightening financial conditions, the Fed can kill off demand and "cool down the economy". Usually with a side effect of a recession. But hey! Look – price stability! Yay! Sorry you lost your job.
- Since the demand drops lower than supply, inflation ceases to be an issue. Prices can even start falling as the economy contracts, and unemployment levels are high
- While politicians promise jobs and economic prosperity, the Fed drops rates to zero, orders a new ink cartridge from HP and is ready to save the day again
- The cycle completes.
When the Fed was trying tame inflation by reducing demand, we assumed the supply to be constant and stable. But the supply is fully at the mercy of other external factors, such as cost and availability of labour and raw materials used in the production process.
- For instance, if there’s a sudden shortage of commodities, supply will decline. And what if it falls faster than demand?
- In that case, the imbalance will still persist – the demand will remain higher than the supply, even though both are falling. That means we’re still in a situation where more money is chasing fewer goods, and inflation isn’t going anywhere
- But the fun bit is that both supply and demand are decreasing, which means RECESSION! The economy is contracting while inflation is high – a.k.a. stagflation. Fed's dual mandate is out of the window as they fail on both of their objectives.
The Fed can only control the demand side of the economy by setting interest rates and expanding/contracting the money supply (QE), thereby impacting consumption, spending and investing. But when it comes to the supply side, the Fed’s magic toolbox doesn’t work anymore. They can’t pull some extra semiconductor chips out of their reserves. They can’t print an extra billion barrels of oil and put it on their balance sheet. They can’t build more container ships to speed up the transfer of goods from China. And unfortunately, they can’t achieve peace in Eastern Europe. Effectively, they have a problem that money can’t fix.
Until the supply-side issues are resolved, it’s questionable how effective the Fed’s toolkit will be at stabilizing the purchasing power of regular Americans.