In June of 2021, we speculated about the possible risks of inflation (see article), and now 1 year later, we are not only dealing with the negative consequences of easy monetary policy, which is contributing to inflation, but we are in the midst of historical geopolitical issues further exasperating the issue.
What really caused inflation? The answer is quite simple.
It is an imbalance of too much demand (caused by excess cash in the system) with not enough supply. Or in other words, lack of labor and productivity against high demand of consumer products/ services.
High levels of stimulus was created and handed out to not just consumers directly, but to banks by flooding the banking system by the purchases of Treasury's by the Federal Reserve. At the time, it seemed to be their only option but I believe they made drastic error (but how could they have known?) by miscalculating the return of labor. Some caused by taking early retirement, while others simply did not return back to their former employers.
The BLS or Bureau of Labor Statistics, which displays the employment numbers, is marks unemployment at 3.7%, while the "Productivity" decreased to 4.1% (see note below for measurement of Productivity) proving that the supply side is being constricted.
In order to fight inflation, the Fed needs to take bold and "painful" steps in order to avoid a wildfire of rising prices.
Before we go any further, let us dive into defining who the Fed is and their overall function when it comes to our banking system within the economy...
Who is the Fed and how does Monetary Policy work? The Federal Reserve is a “Central Bank” which acts as an overseer of all other commercial banks and financial institutions. Main functions of the bank are:
They establish a set reserve requirement
maintains that banks do not over lend comparatively its customers savings amounts held
Set interest rates, such as the Federal Funds Rate
Rate that is charged by a commercial bank (JP Morgan) to another commercial bank (Wells Fargo)
This effect trickles down to the consumers/ businesses who wish to take out a loan. This would also impact credit card rates.
Control the actual supply of money within the banking system (most impactful).
Stimulus – Increase cash at banks by purchasing securities such as bonds, from the banks in order to replenish cash reserves. Adding cash reserves will allow the commercial bank to continue to lend to the public/ consumers. (A simple analogy would be filling a car's fuel tank with gas, where the tank represents the bank, and the gas represents cash reserves. More gas, more trade; more cash reserves more lending)
Pro: Incentivizes additional lending, therefore attempts to improve economic growth due to the spending of consumers and businesses by the receiving the loan or credit line.
Cons or Risks: Inflation = high supply of money + high demand of limited quantity of goods and services.
Tightening – Reduce cash at banks by selling or “rolling off” the securities at the banks; in other words, demanding that the bank pay back the debt or stimulus that was loaned to the commercial banks.
Pro: attempts to reduce inflation by reducing customers ability to borrow
Con: Liquidity risk, low economic growth and possible extreme market volatility.
Image: Federal Reserve's Balance Sheet since 2007
Now you may be asking, why do we care about this or what is the significance of understanding this. Well, in my opinion it is extremely vital to understand this because it "could" lead to the avoidance of significant losses or pose great opportunity when dealing with your own investments if anticipated correctly.
In Part 2, we will dissect what we believe is to be the largest risk to the financial markets, the $8.9T balance sheet that is set to be reduced, starting in September 2022. We believe this could carry 3 main risks. More to come.
Terms & Definitions
Productivity: A measurement of economic performance that compares goods and services being produced to the amount of inputs that is used to produce those goods and services (source: BLS.Gov Productivity 101)
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