The Other Reason The Stock Market Fell 725 Points: The Federal Reserve Is Struggling With Its Inflation Strategy

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By letting inflation “temporarily” get the upper hand, the Federal Reserve is playing with fire. The various Fed members’ speeches provide mixed messaging. Even Fed Chair Powell’s House and Senate commentaries introduced inconsistencies. (See The Wall Street Journal July 16 article, “Powell Concedes Anxiety on Inflation.”)

Clearly, the Fed is wrestling with the best way to handle the rise in the inflation rate above 2%. Wishful thinking on their part is that unexpected demand growth and supply shortages are producing temporary higher inflation that will fall back to the 2% level soon.

The problem with that logic isn’t in the data analysis. It’s the lack of focus on the underlying driving forces that produce inflation – namely, the changing attitudes of companies that are raising prices not due to shortages, as well as the reactions of consumers to those increases. Already, price-raising is becoming a widespread company “tool” for increasing or maintaining profits. Consumers are noticing and reacting as reflected in the unexpected drop in consumer sentiment.

Here are the dynamics at work:

How and why companies cause inflation

Naturally, companies defend their price-raising actions by citing cost increases. In other words, it’s an innocent self-defense reaction to the pricing actions of others. Left unchecked, that reaction simply passes inflation along, creating an inflationary circle of economic life.

However, the cycle is clunky in reverse. A company’s higher prices are “sticky.” That is, when the cost pressures diminish, companies are hesitant to cut the prices (and their profits). Only a driving pressure will produce a cut (e.g., the threat of or actual lower sales due to price-based competition or negative customer reaction).

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Importantly, that cost-push rationale for raising prices applies not only to end-product and service companies, but also to companies up and down the supply chain where price increases in land, construction, equipment, commodities, services and wages eat into profits.

As to wages, three factors are helping push them up now:

  • The minimum wage increases enacted or discussed also raise expectations of higher pay at the levels above minimum wage, especially now when there is high job availability
  • Unfilled demand of skilled and specialist employees, particularly in growth industries, is driving wages and benefits up
  • Increasing worker mobility and a willingness to change jobs means that companies, to retain current employees, must keep their pay and benefits competitive

Consumer reactions

From the late 1960s through the early 1980s, inflation was a special concern, and numerous books and articles were written to help consumers “beat inflation.” The problem then was not only the level of inflation, but also the fact that the rate kept rising. The specter now of an increasing rate of inflation is becoming a concern despite the Federal Reserve’s reassurances that all is under control.

Examples of actions to mitigate the inflationary hit to consumers are:

  • Ask for a raise (be a squeaky wheel)
  • Postpone large purchases, such as appliances and autos
  • Be a wise shopper – Substitute lower cost items for higher priced ones, look for sales and shop in bargain stores
  • Reduce discretionary spending: Dining out, vacations, do-it-yourself projects and entertainment

A timely article in Barron’s (Jack Hough, July 19) discusses one of today’s growing entertainment expense areas that may be ripe for trimming: “Subscription Fatigue May Be the Next Front In the Streaming Wars.”

Investor reactions

There is a lack of investor understanding regarding the effect of rising inflation on investor attitudes. The reason is the generally tame, narrow range of 1% to 2% that inflation tracked over the past 13 years.

In addition, the Federal Reserve policy of near-0% short-term yields over most of that period weaned investors off the notion of “real” return – that is, a yield that at least equals, but more often exceeds the inflation rate.

The bottom line: Normality is approaching

Expect a “normal” inflationary rate rise and “normal” investment adjustments to produce changes that likely will seem abnormal and worrisome to many investors

If inflation makes an extended move above 2% (and, why not? – that’s not some predetermined, pivotal level), the Fed will be forced to act and raise interest rates to prevent the upsurge from gaining steam. The question is, will rising bond yields boost investor interest, or will the accompanying, falling bond prices create angst?

A period of rising inflation and interest rates is also when many business leaders of weak and over-leveraged companies will get a hard-knocks education. Neither a good story nor a charismatic leader will be able to counter the new reality. Rolling over the leverage will become high-priced or unavailable. A sinking stock will accompany the weakened fundamentals as investors focus on wise company management, a sound business strategy and financial strength.

All these shifts may seem upsetting at the time, but they are simply a readopting of sound business and investment management practices. Investors who adjust to the shift will earn good returns.

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