FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
November 9, 2021

IN THIS ISSUE:

1. Overview: Fed Announces Decision To Cut Asset Purchases

2. Fed’s Balance Sheet Exploded Due To Massive Stimulus Purchases

3. What’s Causing Unexpected & Persistently Higher Inflation?

Overview: Fed Announces Decision To Cut Asset Purchases

The biggest news over the last week, if we want to call it news, is the fact that the Federal Reserve finally made it official it will begin to reduce its enormous monthly purchases of US Treasury bonds and mortgage-backed securities later this month. I question whether this was really news or not, since the move was widely expected and surprised no one. The financial markets hardly reacted at all to the news.

The Federal Reserve announced last Wednesday it will begin winding down its aggressive pandemic-era stimulus measures, a process Wall Street nerds call "tapering." But what, exactly, does that mean? The short answer: Money has essentially been free for the past year and a half, thanks to the Fed's double-barrel approach to economic stimulus – interest rates near zero and a massive monthly investment in bonds and mortgages which keeps yields near rock-bottom.

When the Fed eases off the stimulus pedal, borrowing could grow more expensive, making businesses pay more, which means less profit, which means Wall Street is...well, sad. While it might sound somewhat academic, the results of the Fed's decision could have a significant impact on everyday people over time, especially those looking to buy a home or borrow money to run a business.

To understand how we got here, let's flash back to March of 2020, when Covid-19 landed like a bomb on US shores. Businesses shut down, at least 20 million people lost their jobs in a single month and Wall Street was in full-on panic mode. In just under a month, the S&P 500 – the broadest measure of Wall Street – lost more than 30% of its value. If you were brave enough to peek at your retirement account during that time, it was a grim sight.

Essentially, the Fed decided to lower short-term interest rates to near zero and add massive amounts of liquidity to the US economy to get us through the COVID recession. Without getting too in the weeds about the Fed's balance sheet, the thing to understand here is that a big part of the central bank's job is to ensure financial stability, and it does this by controlling the amount of money sloshing around in the economy. By buying up government debt and mortgages, the Fed was essentially turning on a money spigot.

And it has been keeping that up ever since, to the tune of about $120 billion a month in Treasury bonds and mortgage-backed securities. Now the Fed says it will begin reducing its monthly asset purchases by $15 billion per month ($10 billion fewer Treasury bonds and $5 billion fewer mortgage-backed securities each month) until purchases fall to zero around May of next year.

Fed’s Balance Sheet Exploded Due To Massive Stimulus Purchases

Given these historically large monthly securities purchases, the Fed’s balance sheet exploded over the last year and a half. As you can see below, the Fed’s balance sheet was just over $3 trillion when it began the huge bond and mortgage buying program early last year. Now the balance sheet is over $8 trillion and is expected to top $9 trillion before the stimulus program is completely wound down next year. No central bank in the world has ever gone on a spending spree of remotely this magnitude. No wonder we have the highest inflation in 30 years! But that’s another story I’ll get to later.

With that huge supply of easy money, investors came back from the brink in the spring of 2020. By April of last year, the stock market began to rebound, even as the broader economy faltered and the public health crisis worsened. This disconnect between Wall Street and Main Street persists in part because the Fed has kept interest rates near zero and assured investors it would continue its easy-money policy for as long as needed to get the economy back on track.

However, at the latest meeting of the Fed Open Market Committee, the members decided the economy had recovered sufficiently so that it could begin to reduce the monthly asset purchases and eventually shrink the Fed’s balance sheet, with the goal of ending the stimulus purchases by mid-next year. Those debt purchases were emergency measures implemented to stave off calamity and were always expected to be rolled back once it was clear the economy had enough momentum to recover from the short-lived but severe pandemic recession of 2020.

The good news is the economic recovery is chugging along as more people get vaccinated, return to work and in many ways are resuming their pre-pandemic lives. That means it's time for the Fed to wind down, or taper, its debt purchases.

It's a delicate process, and Fed Chairman Jerome Powell has until now been cautious, and at times cryptic, about how and when the taper might begin. Slamming the brakes would trigger an investor panic, but not slowing down would fuel more inflation. So, Powell has dropped numerous hints that the taper was coming over the last couple of months, and with the release of the minutes from the recent policy meeting in September, it official: The taper is on.

What’s Causing Unexpected & Persistently High Inflation?

When the US Consumer Price Index jumped above 4% in April and then above 5% in May and June, Fed Chairman Jerome Powell assured us the increase was only “transitory,” meaning it should only last a few months until some temporary kinks in the supply chain were worked out. If you recall, I questioned his assessment at the time by reminding us all that inflation often tends to have a mind of its own – which is indeed proving to be the case again this time. Not only has inflation risen higher than Mr. Powell expected, it is lasting longer than he suggested as well.

At his press conference last week following the latest Fed policy meeting, Powell admitted inflation has not only risen higher than the Fed wanted but it could well remain at these elevated levels until sometime next year. So much for transitory! As you can see below, the CPI is above 5% today and is close to the previous peak seen in 2008 during the last serious recession/financial crisis. There’s also no assurance we’ve seen the peak. Time will tell.

This sudden jump in inflation has many Americans wondering what has caused it. Many assume it was mainly caused by higher wages. Some workers, mainly in food service and a few other industries, have gotten substantial wage increases, but median worker compensation is up only 3.7% over a year ago, compared to an increase in the Consumer Price Index of 5.4%. As a result, most workers are still falling behind.

Some economists in the Biden administration assure us it is only a matter of time before the kinks in the supply chain are worked out and the backlog of ships waiting to unload at our ports is wound down and inflation will calm down again. But that is likely wishful thinking as the backlogs continue to build at ports in the west. The big source of the price increases is supply bottlenecks caused by an overreliance on a global supply chain, coupled with corporate concentrations and shortages which have developed over time. Let’s take a quick look at some of the main issues.

Overwhelmed Ports. The problem begins with super-sized container ships off-loading at our ports. In the late 1990s a large cargo ship had around 6,000 containers. Today, a large container ship – many of them Chinese state-owned – has 20,000 containers. Only a few ports, such as the Port of Los Angeles, can handle ships this large. At the Port of Oakland, there are idle gantry cranes because they cannot handle the largest ships. In theory, the US government could limit the size of container ships and spread out the traffic, but this entire industry is unregulated.

Trucking and Rail Shortages. After a ship is off-loaded, the containers go either by truck or by rail to warehouse districts to be broken down and transshipped to their final destinations. There are widespread reports of shortages of truck drivers. Likewise, there has been a decline in railroad shipping in recent years. Here, too, the government could in theory intervene, but these sectors are also largely unregulated.

Semiconductor Shortages. Three decades ago, most semiconductors were produced domestically, and most semiconductor companies were integrated. They both designed and fabricated the chips. Over the past few decades, however, one Taiwanese company, TSMC, which was financed by the Taiwanese state in the late 1990s, has come to monopolize several categories of customized chips. This reliance on Taiwan plus South Korea’s Samsung, coupled with a sudden economic contraction followed by a sudden recovery, has led to bottlenecks.

Specifically, when the auto industry had a sharp decline in sales early in the pandemic, it cut back its orders for semiconductor chips. Semiconductor makers shifted their fabrication to computers and other microelectronic products, which were experiencing increased demand as more people were working at home. When automakers wanted to revive production, chipmakers could not shift back on short notice. This led to both scarcity and price pressures in cars and trucks and in the entire advanced economy which relies on chips.

These are just a few of the underlying circumstances which have led to supply chain bottlenecks and significantly higher inflation this year. As you can see, these few circumstances will not be corrected quickly or easily. And there are others I did not mention. I’ll leave it there for today.

All the best,

Gary D. Halbert

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