The edge of tariff reductions: how we got here

How far ahead of the curve is the FOMC?

I’m on my last month of book leave, but I felt compelled to come out at what seems like a seminal moment in the business/market cycle to discuss how we got here and what the impending rate cuts could mean going forward.

Quick warning: the world is always more complex and nuanced than we see in the media or academia; There are millions of little unknown details, and our penchant for narrative fallacy leads to neat and compelling stories that often lack verisimilitude.

Let’s start at 30,000 feet before zooming in on the details. In the aftermath of the financial crisis, ZIPR/QE sent rates to 0%, fiscal stimulus was largely non-existent,¹ Thus, the post-GFC recovery decade of the 2010s was characterized by weak job creation, weak wage gains, weak consumer spending and modest GDP. Inflation was non-existent and CASH was king.

Historically, this is what post-financial crises tend to look like – except in those times when governments apply the lesson of fiscal stimulus we learned from Lord Keynes to kick-start an economic expansion.

The pandemic has led to a lot of supply problems, but like so much else in the world, the roots of these problems go back years or decades:

-The excess construction of single-family houses in the 2000s led to an underconstruction of single-family houses in the period 2007-2021; a reasonable estimate is that the United States needs 2-4 million single-family homes, especially modestly priced starter homes.

-Just-in-time delivery squeezed a few more pennies into earnings per share (not insubstantial), but the cost was a fragility that led to massive shortages of critical items, especially in healthcare.²

-The labor shortage dates back to 9/11, when the Bush Administration changed the rules on who can stay in the United States after earning a college degree. This was followed by a decline in legal immigration, an increase in disability, deaths from COVID-19 and early retirement. A reasonable estimate is that the United States needs 2-4 million more workers to fill our workforce and fully reduce wage pressures.

The delay in the resumption of semiconductor production, which pushed up the prices of new and used cars; became a significant element of the initial round of price increases.

Finally, I have to mention Greedflation.³ I was skeptical when the term first came into use, naively believing that companies only raised prices when they had to, so as not to lose the long-term goodwill of customers.

My views have evolved since then.

The term is defined as companies taking advantage of the general chaos surrounding rising inflation to raise prices by far more than input costs have risen. It is not a price increase itselfbut more general”Hey, everyone else is raising prices, why not us??” If company management is there to (presumably) maximize profits, then pricing above volume is what many companies have done to great effect.

Profits hit all-time highs, helping propel the stock market to ATHs as it climbed the wall of worry and chronic bears and naysayers.

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In this complex mess, a once-in-a-century pandemic occurs.

A few weeks before this happened, in DC, Congress was tied up with renaming a few schools/libraries (it didn’t happen). The NBA then shut down live games and a cascade of shutdowns across the economy followed.

The country along with most of the world is shutting down.

Fear levels have risen. The inability to pass even the most basic legislation was overcome by panic, and Congress passed the largest fiscal stimulus as a percentage of GDP since World War II in the CARE Act (I).

Most observers were upbeat, but full credit goes to University of Pennsylvania School of Finance Wharton Professor Jeremy Siegel. He observed that such an enormous fiscal stimulus would lead to a huge, albeit transitory, increase in inflation.

And he was right.

With FMH people and the service economy partially temporarily closed, consumers have shifted to consuming goods. Our 60/40 economy has become a 40/60. Give people stuck at home big stimulus checks and the result will be a massive demand for goods that makes prices scream every time.⁴

Inflation exceeded the Federal Reserve’s 2% target in March 2021; by December ’21, the CPI was over 7%. It will peak in June 2022 at 9%. It went down again almost as fast as it went up.

By June 2023, it was obvious to any observer who understood how the BLS models worked that inflation had been defeated. CPI fell to around 3%, but that measure was somewhat high because it included a lot of lagged housing and rental data.

The Fed is a large, conservative institution. It moves slowly. Their incentive structure is asymmetric: they are much more concerned with “Not being wrong” than “Being right”.

This complexity is not as contradictory as it might sound.

Consider the possibility of a rate cut in June 2023 (as we argue then). If it was cut too soon and inflation flared up, it would look foolish. If it hadn’t been too early, all it would have achieved was: Providing credit to all the bottom 50% of consumers; ensuring more housing is available; stimulation of CapEx expenses; encouraging more employment; maintaining economic expansion.

But here’s the problem: they would have received exactly zero credit for that result. It was a modest risk with no upside for them.

So instead, they played it safe. They waited until it became obvious that inflation was dormant and the economy was cooling.

We can debate whether the FOMC should have started cutting rates in June 2023 (maybe a bit earlier) or September 2025 (obviously late).

Regardless, rate cuts are coming. They’re probably fully baked into stock prices, which suggests another concern of Jerome Powell’s — not allowing the AI ​​frenzy to turn into a full-blown bubble. That’s a conversation for another day.

Enjoy the rest of your summer!

Previous:
Why the FED should already be cut (May 2, 2024)

CPI rise based on poor shelter data (11 January 2024)

The Fed is over* (November 1, 2023)

Who’s to Blame for Inflation, 1-15 (June 28, 2022)

Inflation Falls Despite the Fed (January 12, 2023)

Why is the Fed always late to the party? (October 7, 2022)

The post-lockdown economy (November 9, 2023)

How Everyone Got Housing Demand Wrong (July 29, 2021)

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1. At the time, I blamed the lack of robust fiscal action on “partisan sabotage,” but this was widely shared by both the left and the right. CARES Acts 1 and 2 (under Trump) and 3 (under Biden) only served to confirm that earlier observation that we know what the appropriate playbook looks like; when we don’t implement it, it’s usually for all the wrong ideological and political reasons.

2. This is a matter of national security and I support the federal government mandating a 90-180 day supply of those critical to the health and welfare of the nation. If all companies MUST have a 3-month supply of widgets, then it shouldn’t affect stock prices other than who builds a supply most efficiently. And big penalties for storing cheap foreign-made junk that won’t work when needed.

3. And its cousin Shrinkflation.

4. By the end of 2021, vaccines had become widely available and the beginning of the end of the pandemic was in sight. What followed was the summer of revenge travel, more spending on services and a slow return to, if not normal, then close.