Easy Money And The Risks Of Inflation

A dollar bill painted on a chalkboard in the shape of a growth graph with an upward-pointing arrow… [+] indicating economic links.
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According to Jim Stack, a “safety-first” money manager, editor of InvesTech Research, and writer to MoneyShow.com, investors in today’s stock market have become drunk by the Federal Reserve’s unprecedented — and seemingly perpetual — loose money policies.
Despite the potentially hazardous repercussions of building asset bubbles, Fed officials have all but guaranteed to keep the celebration going. This new path began more than two years ago, in December 2018, when the stock market plunged -9.2 percent, the greatest December loss since the Great Depression.
Fearing a backlash, the Federal Reserve quickly changed its aggressive attitude and began reversing its previous nine Discount Rate hikes. Despite no strong indications of recession, the easing persisted until the COVID-19 outbreak struck last year, prompting the Fed to make the ultimate panic cut in short-term interest rates to 0%.
This sloshing 180-proof liquidity has fueled some of the most speculative nonsense in market history, including record high margin debt, an IPO mania that dwarfs most predecessors, esoteric digital art called Non-Fungible Tokens (NFTs) that sell for millions, and a Cryptocurrency craze that is starting to resemble the Tulipmania of the 1600s, including two latest crypto-trader favorites: $ASS and $ASS
Unfortunately, this extra liquidity has exacerbated unexpected inflation pressures, as Citigroup’s “Inflation Surprise Index” has shot to a 23-year high, in addition to soaring stock market values and another possible housing bubble. Nonetheless, the Fed Chairman was adamant about keeping the punch bowl filled.
ADDITIONAL INFORMATION FOR YOU

The Citi Inflation Surprise Index is a measure of how surprised people are about inflation.
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To suggest that the Federal Reserve has exceeded its inflation target is an understatement of historic proportions! The Core CPI, which excludes volatile food and energy costs, has risen to 3.8 percent, its highest level since 1992!
Similarly, Core Personal Consumption Expenditures (the Fed’s preferred inflation indicator) has risen to 3.1 percent, considerably beyond the central bank’s 2 percent objective, prompting many to ask how much higher inflation must rise before the Fed intervenes.

Personal Consumption Expenditures versus. Core Consumer Index
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The biggest unknown, as well as the most significant risk, is whether today’s inflation spike will be temporary or permanent. We use a methodology developed by the Atlanta Fed called Core Sticky Price CPI to assist us answer this question. Medical treatment, car insurance and repair, dining out, alcoholic beverages, and owners’ equivalent rent are examples of commodities and services that fluctuate in price somewhat occasionally.
Over the last three months, Core Sticky Prices have risen at an annualized rate of 4.6 percent, the greatest level in 30 years.
While we recognize that some components of today’s inflation may lessen when the current supply chain issues are resolved, this indicator emphasizes that there are significant areas of inflation that will likely endure. As a result, we must critically consider if this increase in inflation is only temporary.

CPI Core Sticky Price
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Inflation’s “stickiness” is affecting the corporate sphere as well. Every month, the National Federation of Independent Business (NFIB) conducts a survey of small business owners to determine their pricing strategies for the future.
Currently, a net 43 percent of small business owners intend to raise prices in the next three months, the largest rate since the late 1970s’ double-digit inflation era. The need to pass on increased input and labor expenses is driving these escalating pricing pressures.
Consumers must be concerned about inflation, as they have grown acutely aware of recent price increases. Every month, the University of Michigan conducts a consumer survey in which it asks a slew of questions on the economy. This indicator not only gives information regarding consumer attitude in the United States, but also the more specific reasons for their responses.
Consumers reported high prices as a main reason that buying conditions have deteriorated in all three of these major categories — housing, vehicles, and durable goods. Indeed, the percentage of replies that mentioned house prices being too high hit an all-time high, nearly twice the figure seen during the previous housing boom!

InvesTech Research on Consumer Sentiment
These data points are not only eye-catching, but they also relate to the behavioral component of inflation and how it can have a negative impact on individual purchasing decisions. More crucially, these data suggest that inflationary psychology may be gaining traction for the first time in decades.
Meanwhile, our worries about a looming housing bubble have grown significantly in the last year. Such concerns stem from the fact that traditionally, house prices have linked closely with long-term inflation, which is no longer the case.
The graph below depicts the tremendous divergence that existed during the House Bubble from 2005 to 2007, as well as the painful resolution that occurred when housing prices fell during the Great Recession.
While the extremes of subprime mortgage debt aren’t as visible in today’s real estate market, the lack of affordability and present reliance on record-low interest rates are possibly more harmful.

Inflation Versus. Housing Prices
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We would also remind investors of the Bureau of Labor Statistics’ decision in 1983 to replace home prices in the CPI calculation with “owners’ equivalent rent” (OER). This was originally designed to counteract the inflationary impact of rising home prices in the 1970s.
Although this adjustment to the CPI was successful in lowering reported inflation, it dramatically misrepresented inflationary pressures on Main Street. For example, the government’s measure of OER has climbed by only 2% in the last year, while median single-family housing prices have increased by a stunning 20%!
The graph below depicts the possible difference between a CPI calculation based on the real median family home price and the existing OER-based CPI.
The current Home-Price-Adjusted CPI reading is a surprising +10.4 percent, implying that the level of inflation recorded in reported CPI for today’s homeowners is the lowest since the changeover to OER!

CPI for Households Adjusted compared. CPI for All Households
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The economic reopening and recovery have been stronger than virtually everyone projected at this point in 2021.
While this is welcome news, we are concerned about the Fed and Treasury’s massive amounts of liquidity, which are fueling sky-high house prices, stock market speculation, and inflation (too many dollars chasing too few goods).
Some of the data and images in this issue are concerning, particularly for individuals who are concerned about inflation in their daily lives. Our goal isn’t to scare you, but to keep you informed and give you advice on how to manage your portfolio through the coming uncertainty.
When it comes to stock market investment, skepticism can be a beneficial trait. However, it is frequently a taught trait that emerges only after a series of hard bear market and recession experiences.
As a result, we continue to be suspicious of the Federal Reserve’s guarantee that today’s inflation pressures will be “transitory.” We know far too much about history, and the facts on the inside simply does not support the Fed’s position.
Except in textbooks and among those old enough to recall, the progressively greater inflationary cycles of the 1960s and 1970s are largely forgotten. The fact that none of the current members of the Federal Reserve Board of Governors were beyond the age of 26 when inflation was last roaring, including Chairman Jerome Powell, doesn’t inspire any more confidence.

Board of Governors of the Federal Reserve System
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We don’t think double-digit inflation, as seen in the 1970s and early 1980s, is on the horizon. However, public perception is changing, and there’s a chance that inflation may be hotter and stickier than the Fed expects, pushing them to tighten monetary policy sooner than they’ve predicted.
This type of climate necessitates a different investment philosophy than has been required in a long time.
While the Model Fund Portfolio has been positioned for the likelihood of inflation over the past year, our most recent incremental adjustments are focused on rotating even more toward holdings that not only benefit from the economic recovery, but also benefit from inflation.
International shares offer an attractive method to participate in the post-pandemic rebound while also addressing valuation and inflation concerns.
Furthermore, due to the inherent inverse link between the US dollar and crude oil, the Energy sector is well positioned to profit from higher demand associated with the recovery and tends to perform well during periods of sustained inflation.
We urge that we boost our holdings in the MSCI ACWI ex-US SPDR ETF (CWI). International stocks offer a built-in hedge against the dollar’s decline while also addressing valuation risk.
We also suggest increasing our holdings in the Energy Select Sector SPDR ETF (XLE). In an inflationary environment, commodities exposure in the energy sector can be advantageous.
While strong technical data continues to justify giving this bull market the benefit of the doubt, we remain wary of rising risks.
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