Can the Federal Reserve Smelt Steel?

One year ago, US Federal Reserve (Fed) Chair Jerome Powell unveiled a change to the Fed’s inflation targeting objectives, culminating a multi-year strategy review process. That review stemmed from the Fed’s chronic failure to hit its 2% y/y inflation target, installed in 2012, with price increases throughout the 2010s deemed too low.^[i] The solution announced a year ago: Instead of targeting 2% inflation in every given month, they would now target “inflation that averages 2% over time.”^[ii] They didn’t unveil a precise formula or define “over time,” leaving many financial commentators we follow to presume the Fed would tolerate a spell of relatively hot inflation if the long-term average over some arbitrary period was 2%. There was some cheering at the time, but that was before US Consumer Price Index inflation spiked over 5% y/y and the Fed’s targeted gauge, the Personal Consumption Expenditures price index, hit 4%.^[iii] (Both indexes aim to measure price changes across the broader landscape of goods and services.) Now many commentators are calling for the Fed to change tack again, either going back to the old targeting system or clarifying precise boundaries. In our view, this all misses the point greatly, as our research indicates there is little the Fed can do about the issues driving prices now—a point we think investors benefit from understanding.

We agree with the broad school of thought that views inflation, defined as a broad, consistent increase in prices across the entire economy, as a monetary phenomenon—too much money chasing too few goods. This, the Fed can theoretically influence with short-term interest rates, which it can raise or lower to flatten or steepen the yield curve (a graphical representation of a single issuer’s interest rates across a range of maturities), respectively. (The Bank of England and European Central Bank (ECB) operate in much the same way.) In a modern system like the US or UK, banks create most new money by holding only a fraction of every new loan in reserves, so fast lending generally speeds money supply growth (and vice versa). When yield curves are steep, with long rates comfortably above short rates, banks’ core business model—borrowing at short-term rates and lending at long-term rates—generally becomes more profitable. Our research shows that makes lending more attractive for banks, so they do more of it, and money supply grows swiftly. When the yield curve is flat or even inverted, we think aggressive lending becomes much less profitable. Banks tighten their belts. Our research has found this slows or, in some cases, reverses money supply growth. Eventually, we think those money supply changes feed through to prices.

It may be tempting, therefore, to look at last year’s money supply spike and think that was the trigger for today’s high American inflation rates.^[iv] But money supply isn’t the only monetary variable. We think velocity—the rate at which money changes hands—also matters a great deal. If supply is up while velocity is down, they can offset each other at least partially. We think that is mostly what happened last year. Velocity tumbled as lockdowns blocked sales and hit incomes.^[v] The Fed’s big money supply increase mostly offset that plunge, in our view.

Now, even with much of US society reopened, the official measure of velocity is still crawling around its pandemic-era low.^[vi] Meanwhile, money supply is growing much, much more slowly—true of M2 money stock, which has all the things society uses to buy goods and services, and broader measures like M4.^[vii] America’s spread between 3-month and 10-year government interest rates has shrunk by about half a percentage point and is now in line with not-at-all-inflationary 2017 and 2018.^[viii] In short, the monetary backdrop doesn’t look to us like anything the Fed would traditionally need to do something about.

In our view, the most common explanation for this year’s spiking inflation metrics is largely correct: Supply shocks. Distortions related to reopening in the West and renewed lockdowns in parts of Asia are disrupting the production and shipping of goods globally. According to basic economic theory, the price of every good stems from supply and demand. Therefore, shortages naturally push prices higher. Today’s shortages arrived as Western economies reopened and demand improved, creating a perfect storm. Raising short-term interest rates won’t change this basic conundrum.

As a result, commentators calling for the Fed to shift course and do something about prices now might as well be asking the Fed to:

• Drill for oil
• Mill lumber
• Fabricate semiconductors
• Build autos
• Farm cattle, hogs and poultry
• Smelt iron ore into steel
• Build container ships
• Build shipping containers
• Automate the unloading of container ships to ease backlogs at American ports
• Convince China to stop closing ports every time there is a COVID case on site
• Fill in at Vietnamese ports whilst dockworkers are sidelined with COVID
• Work as line cooks and restaurant servers
• Man the hotel concierge and check-in desks and join the housekeeping staff
• Moonlight as flight attendants and pilots

Now, perhaps Powell and his Fed friends are talented people who could do some or all of these things in their spare time. But at an official level, everything on the above laundry list is far outside the Fed’s sphere of influence. Monetary policymakers can’t bring new supply capacity online tomorrow any more than they can magically wave COVID out of existence. They are limited to monetary policy tools only.

We think the rising prices in these areas will eventually self-correct given time. Higher oil prices, for example, have already begun to encourage producers to ramp up output—same for steel and many other raw materials.^[ix] US lumber prices remain elevated on the consumer side, but prices used by producers and wholesalers are down hugely from highs seen earlier this year.^[x] In time, this should bleed through to retailers. Never forget another basic economic tenet: Prices send signals.

We won’t go so far as some who have warned of the dangers of the Fed raising interest rates during a supply shock. That crowd of commentators points to the ECB’s decision to hike rates in mid-2011, which we think is rather irrelevant to today’s situation. Tightening into a brewing debt crisis is quite different than tightening into a combination of robust demand and limited supply, and in our view, the ECB has always shouldered too much of the blame for the Continental European recession that followed. We think it is quite fair to say rate hike didn’t make Greece default (twice in 2012) or governments throughout Southern Europe implement austerity on the heels of the global financial crisis. Our point is simply this: The Fed’s price-fighting power is limited right now, and in our view, the more investors globally understand that, the easier it will become to sift through the financial news.