Inflation Fight Night: Fed Chair vs. The Senator

The three-round exhibition fight occurred on Tuesday, March 7, when Federal Reserve Chairman Jerome Powell testified before the Senate Banking Committee. Both opponents arrived well-prepared for the bout, which led to an exciting showdown. Given their influence, this commentary focuses on the main points of the exchange, intending to provide a politically unbiased view of the problems and the possible, appropriate investment solutions.

Here are the issues around which each round was fought.

Round #1: The Fed cannot tame inflation with higher interest rates alone

We agree with Senator Elizabeth Warren that the fight against inflation cannot be fought exclusively by wielding the demand destruction that results from higher interest rates. She specifically mentioned “price gouging,” “supply chain kinks,” and the “war in Ukraine” as inflationary forces that cannot be controlled through monetary policy.

The term “price gouging” is used to vilify companies for passing along increased costs to consumers. The declining profit margins of companies in the S&P 500^® Index reveal that corporations are not “gouging” but suffering from high inflation—just as are individuals.

S&P 500 Operating Margin vs. CPI

Source: Bloomberg, Data as of 3/2023. Past performance is no guarantee of future results.

While “supply chain kinks” were once a significant source of high prices, the evidence suggests this is no longer true. As measured by the Federal Reserve Global Supply Chain Pressure Index, supply chains have corrected mainly and are now back at pre-COVID-19 levels. Supply chains likely are neither now nor will be a major source of inflation going forward.

Global Supply Chain Pressure

Source: Bloomberg, Data as of 2/2023. Past performance is no guarantee of future results.

We do, though, agree that the war in Ukraine further aggravates inflation and that the economic consequences are likely to last for an extended period. War, in general, is highly inflationary because it diverts away productivity and efficiencies across global economies. The chart below demonstrates how periods of war have historically coincided with higher inflation.

U.S. CPI YoY Change (%)

Source: Bloomberg, Data as of 12/2022. Past performance is no guarantee of future results.

Since restrictions on the availability of commodities have global inflationary implications, this conflict is particularly inflationary given the significance of both Russia and Ukraine as commodity producers. The chart below demonstrates just why Russia is such a commodities powerhouse.

Top 5 Countries in Global Production (2020 – 2021, Descending Order)

Source: Bloomberg, Company Data, Goldman Sachs Global Investment Research, Argus, WoodMac, USDA, USGS. Data as of 1/2022. Past performance is no guarantee of future results. Not intended as a recommendation to buy or sell securities of any sector mentioned herein.

However, we believe Senator Warren left out four very key risks that illustrate why monetary policy alone may not be enough to combat inflation:

1. The use of debt monetization to finance government overspending.
2. The failure to invest in the production of traditional energy.
3. The fact that “social spending” increases aggregate demand.
4. The cost increase resulted from de-globalization (e.g., on-shoring in the U.S.).

In the interest of brevity in this piece, we can expand upon these topics in future commentaries.

Round #2: The Fed will likely cause a severe recession, and many people will lose their jobs

Senator Warren points out that, since the end of WWII, there have been 12 times when the unemployment rate increased by 1% or more within one year, and each time it resulted in a recession. Furthermore, once the economy starts losing jobs, it typically “turns into a runaway train that is very hard to stop.” In 11 out of those 12 times, unemployment rose at least another 1% or more after the initial 1%.

We agree and expect a hard landing. The chart below demonstrates the cause-and-effect relationships between inflation, interest rates, and unemployment. The last inflationary event of a similar magnitude was in the 1970s, resulting in a double-digit unemployment rate. While we do not believe such a severe downturn will emerge, the historical data cast heavy doubt on the expectation of a soft landing.

CPI vs. Fed Funds Rate vs. Unemployment

Source: Bloomberg, Data as of 12/2022. Past performance is no guarantee of future results.

Round #3: Fire Powell

Senator Warren concluded her statement: “Chairman Powell, you are gambling with people’s lives. We need a Fed that will fight for working families. If you are not going to lead that charge then we need someone at the Fed that will.”

While this rhetoric may be politically expedient for Senator Warren, firing Chairman Powell will not solve the problem. Higher interest rates, in coordination with the resolution of supply-side bottlenecks, are necessary weapons in the fight against inflation.

The unkind truth is that millions of jobs will likely be sacrificed to ease the inflation burden on over 330 million Americans. The charts below demonstrate that, in the aggregate, the cost of inflation is much more substantial because it impacts everyone, not just those losing their jobs.

Lost Real Income Per Increase In Unemployment

Lost Real Income Per Increase In Inflation level

Source: St. Louis Federal Reserve Bank. Data as of 9/2022. Past performance is no guarantee of future results.

The Fight Result

After three rounds of vigorous action, we go to the scorecards and declare the victory to Senator Elizabeth Warren by a slim margin. The most important takeaway was that high inflation must be addressed from both the demand and supply sides. Destroying the economy to bring the balance between demand and supply in line is only a temporary solution, at best. Eventually, the Fed will be required to relent. And, unless the supply-side issues are resolved, specifically in commodities, our expectation is of a resurgence in inflation.

Investment Solutions

First, you must stop assuming that inflation will just disappear. The chart below demonstrates how wrong the consensus view on inflation has been by comparing the differences between inflation expectations and inflation. Right now, the expectation is that the inflation rate will be 3.9% in 12 months. Will that prove to be right—maybe? Even a broken clock is right twice a day. But don’t bet your nest egg on it.

Inflationary events of the past have occurred frequently (30% of the time, the CPI—the consumer price index—has been above 4%), and globally, on average, these events have lasted well over a decade.

U.S. Inflation & Expectation 2021-2023

Source: Bloomberg, Data as of 1/2023. Past performance is no guarantee of future results.

Secondly, consider a 10-20% strategic allocation to diversified real assets. Real assets have the ability to outperform during periods of high inflation because of the scarcity of physical goods during inflationary events. Our preferred solution is the Van Eck Inflation Allocation ETF (“RAAX”). It offers an adaptive allocation across a diversified portfolio of inflation-fighting assets.

The chart below demonstrates the performance of RAAX, relative to both stocks and bonds, since inflation exceeded 2%.

VanEck Inflation Allocation ETF vs. Stocks/Bonds 2021-2023

Source: Bloomberg, Data as of 1/2023. Past performance is no guarantee of future results. Not intended as a recommendation to buy or sell any securities mentioned herein.

Thank you for taking the time to read our commentary. And cross your fingers if you are not invested in diversified, inflation-fighting real assets.

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