The Fed is Walking a Tightrope with Inflation

By TradeSmith Editorial Staff

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Inflation has been a growing concern for financial markets in recent months, and for good reason. Prices continue to increase at a faster pace.

Federal Reserve officials are walking a monetary policy tightrope as a result, with no margin for error.

A big part of the Fed’s monetary policy mandate is keeping prices stable. However, inflation has continued to accelerate at a rapid clip.

That’s why all eyes will be on the Fed following its December policy meeting, which concludes tomorrow. And its moves could impact markets.

For the longest time, Fed officials dismissed inflationary pressures as “transitory.” They believed supply chain disruptions, triggered by the pandemic, were only temporarily pushing prices higher.

But the Consumer Price Index (CPI) accelerated again last month, climbing at a 6.8% rate year over year. This means inflation is now at the highest level in 40 years.

And it’s showing no tangible signs of slowing down any time soon.

Looking at the Numbers

A look inside the November CPI report shows rents and owners’ equivalent rents on pace to increase at a 5.5% yearly rate. This important measure of housing affordability is now well above pre-COVID levels.

And housing costs are likely to keep rising as the real estate market continues to tighten nationwide. According to the FHFA House Price Index, American home prices are surging 18.5% higher over last year.

That’s the fastest pace of home price increase in the history of the index!

Retail goods price inflation is also running well above trend at 4.5% year over year. That’s in sharp contrast to the deflationary retail price trend (thanks to and other online retailers) that existed pre-pandemic.

And the Producer Price Index (PPI) last month showed input costs for U.S. businesses soaring 12% year over year as employment costs (wages and benefits) rose sharply over last year.

The bad news in this number is that eventually, businesses must pass along higher producer prices to consumers, boosting the CPI even more. Otherwise, their own profitability gets squeezed. And there is already plenty of downward pressure on profit margins now.

The Fed Flips its Inflation Outlook

In response to higher and more-persistent-than-expected inflation, the Federal Reserve just pulled a major about-face on the “transitory” nature of rising prices.

In recent comments to Congress, Federal Reserve Chairman Jerome Powell admitted that “price increases have spread much more broadly in the recent few months across the economy. I think the risk of higher inflation has increased.”

And it’s no surprise that both stock and bond markets turned more volatile in the wake of Powell’s change in outlook on inflation right after the Thanksgiving holiday.

The Fed is now signaling that it will accelerate the pace for winding down its purchases of U.S. Treasury and mortgage-backed securities. That means less liquidity in financial markets.

Plus, the Fed is also talking about raising interest rates much sooner than originally expected, and perhaps at a faster pace. That means tighter monetary conditions for the U.S. economy and financial markets.

That’s why investors will be eager to hear what Powell says and what the Federal Reserve does following its policy meeting Wednesday afternoon.

Inflation and the Money Supply

It should not really come as a surprise to the Fed, or any of us, that inflation is accelerating. After all, the Fed’s own tools clearly show why prices are rising at such a fast pace.

The Federal Reserve Bank of St. Louis tracks the growth of the U.S. money supply, which you can see in the chart above.

The Fed calls this M2, and it includes cash in circulation in the U.S., savings accounts (including money markets), bank deposits, and retail money market funds.

M2 money supply is the lifeblood of the U.S. economy. And the figure above shows the year-over-year growth rate of that money supply, adjusted for inflation.

Typically, the money supply grows around 5% or so during expansions as money becomes more plentiful. And it contracts a bit during recessions when money is tight.

But it rarely exceeds the range of plus or minus 5%. That is, until the pandemic. That’s when the Fed put the pedal to the metal of money supply growth.

M2 surged at a 20%-plus annual rate for nearly a full year between early 2020 and spring 2021. Money supply growth hit a peak of 25.02% year over year in February.

So it’s no surprise that the sizzling growth in the U.S. money supply has also been followed by rising inflation, just as it was during the 1970s.

True, the Fed has been easing growth in M2 in recent months. But it is still inflating the money supply at a rate of 6.4% year over year. That is well above the long-term average.

So when you hear someone on CNBC talk about the Fed committing a “monetary policy mistake,” this is what they’re talking about.

If the Fed is too loose with money growth, inflation is the result.

And if the Fed is too tight with money growth, recession is the result.

The Fed is facing a delicate balancing act, with the health of the economy and financial markets on the line. That’s why it will be interesting to see its latest high-wire act play out on Wednesday.