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Inflation is a Policy

Authored by Mike Petrino, Sr. Portfolio Manager

The most recent measurements of the rate of inflation provide evidence of a significant decline in the rate over the last year. The data show the year-over-year inflation rate has declined from 9.0% in June of 2022 to 3.2% in July of this year. While this rate of inflation is not at or below the Fed’s target of 2.0%, the Fed has made progress in its effort to control inflation in the near term.

At the heart of the Fed’s policies has been an increase in the Fed Funds rate from 0% to 5.3%. The Fed has until recently made efforts to reduce the money supply as well. The rate of change in the monetary base, a measure of the money supply, turned negative in February of 2021, and become positive in May of 2023. The Fed’s effort to reduce liquidity has paused at least temporarily. The Fed has signaled also that it may pause Fed Funds rate increases as well.

The Fed increased the Base in 2008 as a response to dislocations in the financial markets precipitated by the collapse of the sub-prime mortgage market. In 2020 the Fed once again increased the Base as part of an effort to reduce the depth of the recession brought on by a reduction in economic activity that flowed from policies put in place as a response to the Covid-19 pandemic. In total the Fed added about $5 trillion to the base above the trend line growth. Much of that amount remains on the Fed’s balance sheet.

The pause in the reduction of the excess liquidity may reflect a new reality. The Federal Budget is about to produce deficits in the range of $1.5 trillion to $2.0 trillion for the next ten years according to the Congressional budget Office (CBO). Without a willingness on the part of the Fed to finance these large deficits, there is no obvious source of financing. Foreign holders of dollars might step up under normal circumstances, but the current circumstances are not normal. Treasury debt has been downgraded by Fitch, a credit rating firm, and several banks have seen their credit ratings downgraded by Moody’s, another credit rating firm. Holding dollar denominated financial assets may not look attractive or safe.

The Fed faces a dilemma. In the post-WW II period, the Fed stepped up and bought the Treasury’s debt, and an increase in the rate of inflation followed.

When the Fed was established in 1913, the market price for gold was about $20. In 1971 when we shut the gold window, and would no longer allow foreign governments to redeem dollars for gold, essentially ending the gold standard, the price of gold was about $40. The price of gold is just over $1900 per ounce currently. The price has increased almost 100 times since the Fed was established. The Price of oil in 1971 was just under $25 per barrel. Oil is now about $82 per barrel. Oil has tripled in price since we cut the dollar loose from gold.

Investors should bear in mind the insight von Mises offered as we move forward. For instance what long-term impact will Russia-Ukraine war and U.S.-China’s trade war have on globalization and price of goods. Inflation may have abated, but it will return. Inflation is a policy.

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