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  • donaldmattersdorff


During my career I have tried to write to you about markets and economics in clear, basic prose, avoiding graphs and detailed discussion of company financials or economic trends entirely. I used to listen to such presentations, and I usually found them boring and ultimately useless. If an analyst shared with me his or her views, then surely that person had already shared the same views with others, often many others, and the views were already fully discounted in current market prices. Furthermore, I have yet to meet an economic guru (myself included) who predicted accurately more than 50% of the time. The stock market can only go up or down. You have a 50% chance of being correct no matter what you say, and today's prophet is tomorrow's ding-dong. I didn't see the point.

A few of you find this approach simplistic and have said so. But the majority of my clients are too busy and lack the inclination to follow inflation and GDP very closely. They're happy to receive a general sense of what's going on without too much detail, and happy also to stick with the prudent, timeless principles of investing which I promote.

I mention this because today I intend to break with tradition and discuss inflation in more detail, and to include a few charts. If you would like to skip on to your reading, feel free. But for those of you with a little time.... If you want to visualize the severity of our current inflation, don't look at the newspapers. They only report the change in prices over the past twelve months (8.3%, 5.1%, etc.). It's misleading. Look instead at a chart of the actual Consumer Price Index, such as this one:

Source: FRED

This chart shows you in one sweeping glance, our inflation history since 1947. A horizontal line means no inflation; a steeply sloping line means high inflation. Here we see it all.

Note that except for very occasional, brief blips, prices only go up. Although the chart doesn't show it, they have gone up continuously since 1933. Even during periods of low inflation, such as we enjoyed in the 1950s, early 60s, and between 1985 and 2020, prices still went up, and significantly so.

That's as it should be. We never want to see prices go down. You may think I'm joking but I'm not. Economically, deflation is a more serious problem than inflation. It would cause much worse problems for our country. Like everyone, I enjoy an occasional sale at Costco, but that's it. I want nothing to do with systemically falling prices, and I recommend that you think this way also.

Notice secondly the very steady, consistent manner in which prices have risen. It's so steady that the graph is boring: a testimony to the superb management of our currency by the Federal Reserve, across numerous presidencies and changes in Fed leadership. Would that we had such competence in all of our branches of government! The United States would hum.

Alas, nobody is perfect. The sharp upward turn in prices since 2020 stands out, to me, as the most noticeable aspect of the graph, and highlights the severity of our current problem. Where else in this history do you see such a sharp break and upward rise? Maybe between 1978 and 1983, but this one looks sharper still to me.

It was a monetary policy mistake of major proportions - a bone-fide screw-up by the Fed and its current chairman, Jerome Powell - which caused the inflation problem which we experience today. At the onset of the pandemic, Powell reintroduced massive easing, similar in size and scope to the actions which the Fed took during the financial crisis. Only this time, the economy was healthy. Consumption was robust. Unemployment was low. Banks were in fine shape. No stimulus was needed. The Fed took these steps preemptively, to counter disruptions which it expected to materialize.

Maybe, in the earliest days of COVID, that was a reasonable thing to do. I also remember worrying about the many millions of people who worked in restaurants and hotels and travel, not to mention health care and many other industries, and wondering where they would go. Incredibly, they all found other work. Powell should have monitored the situation more closely than he did, and reversed course more quickly when it became obvious that our COVID economy did not need such a huge stimulus and that inflation had begun to build. Others saw it. But by then, he was nearing the expiry of his first term in office. He wished to be reappointed by President Biden, and so, in my opinion, he waited for personal reasons to tighten policy until after his reappointment. Even then, he didn't exactly spring into action.

Not good. Now we have a big inflation problem. It looks to me like an unforced error on the part of the Fed, though immense fiscal stimuli from Congress didn't help. Our economy has overheated, and I think it will require much higher rates and very likely a recession to cool it down again. I see the current situation not as a confluence of unfortunate events, beyond our control, but as a major policy mistake, which we must correct.

Furthermore, high inflation leads to a "yo-yo economy". The Fed will have to tighten so strongly, as it did in the early 80s, that it induces a recession. Then it will ease quickly, as inflation moderates and unemployment takes over all of the headlines. An unhealthy gyration will develop. An important aspect of the Fed's work is to manage monetary policy without over-reacting to the problems of the day, such that we enjoy consistent expectations of growth and inflation as the years pass, without unnecessary volatility. It's very difficult to accomplish - an exercise in fine tuning to the nth degree. But we had that for a long time. Our Federal Reserve has been a genius. Now we've lost it.

But here's a bit of good news. The trend has started to moderate. I actually intended to write about this when I started today. Look at this chart of the last two years. The most recent two months show no inflation at all:

The market went down 1,000 points last Monday after the most recent CPI report (represented by the red dot) but it didn't look that bad to me. What did people expect?

Purists reply that the CPI was worse than what's shown by the dot - that ex food and energy, the index rose 0.6% from the previous month, more or less in line with the upward trend. The purists see a need to exclude food and energy, which together represent 22% of the index, because the prices of those components bounce around on the weather or what some potentate in Saudi Arabia (or Russia) had for breakfast.

Maybe. I see the point. If gas prices fall by 20% based on unique events in the oil markets, while everything else keeps going up, then we still have inflation. But food and energy are included in every other dot on the chart, and I don't really see a need to exclude them this time just because they point to good news. No matter how you slice it, the inflation picture looks just a little bit better right now than it has for the last two years.

I can agree with the consensus, however, that inflation is not over, that we will have higher rates, a slowing economy, and longer to wait for the stock market before things start to look up again.

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