If you want a lesson in the dangers of GroupThink, look no further than the Federal Reserve.

They employ literally hundreds of highly qualified economists from the finest universities in America. Yet, it seems, not one of these geniuses could predict this outcome:

        First, you force people to stay at home for the best part of two years

        Then, you print trillions of new dollars which you spray around in the form of stimulus cheques, furlough programmes and emergency loans

        Then you re-open the economy at a time when global supply chains are shot to pieces by all the disruption

        You then have a flood of that newly minted money chasing a reduced supply of goods and services

        Shock horror, prices start rising. And they keep on rising until we have the highest inflation since the 1970s.

For far too long the Fed refused to acknowledge the seriousness of the problem, insisting it was a transitory phenomenon. Now, as trade unions see a resurgence in membership, organisations attempting to settle wage claims for 2% or 3% are facing a hostile workforce experiencing prices rises of 10-15% in everyday goods. (Americans don’t have the 300% or more energy price hikes that the UK and Europe face but these are arguably a separate phenomenon to the inflation that has directly resulted from the loose monetary policy of the pandemic).

Conflicting Forces At The Heart Of The Conundrum

Jerome Powell is embarrassed. He knows he made an enormous mistake. His actions in recent months suggest that he will now do anything and everything to bring inflation down. He will likely go too far with interest rate hikes and quantative tightening (QT), forcing America and the world into a deeper recession than necessary.

Up to now the QT has been relatively mild, with expiring treasury bonds not being replaced. But don’t for one moment think that gives any support to the bond market. As interest rates rise towards a predicted 5%, so bond yields must rise to reflect the new normal. What makes bond yields rise? Correct, a significant fall in their prices. The forty year bull market in bonds is well and truly over, and with it dies the traditional 60/40 portfolio that your IFA or pension fund manager may still have in place across your portfolio.

But Jerome Powell must face down more than just the bond market if he wants to get the inflation bogey off his back. He must compete with the empty shell that occupies the White House, an increasingly pathetic figure whose understanding of inflation is on a par with Turkey’s dictator Erdogan. Biden puts the ’moron’ into oxymoronic with the naming of the Inflation Reduction Act. Maybe it was those same Fed economists who advised him that printing 750 billion fresh dollars to spend on Net Zero subsidies and other capital misallocations would somehow bring inflation down rather than stoke it up.

The same thing is happening in the UK. The Bank of England raises interest rates again for the seventh month in a row. In the same week the new government announces hundreds of billions in energy subsidies and tax cuts.  Don’t get me wrong, I’m delighted that we are finally seeing some Conservative policies after the Blue Labour era of Cameron, May and Johnson.

The challenge is the combination of tight monetary policy set against loose fiscal policy. Already we are seeing the impact on the pound as it heads towards parity with the dollar. Remainers should note that the euro is already worth less than a dollar as Powell’s rate rises make the greenback the world’s safe haven currency.

Factors That Will Keep Inflation High

Ø  America’s labour market is so tight that there are two jobs for every applicant. Hardly a recipe for moderate wage demands.

Ø  At present we are seeing wage demands rising in the manufacturing sector but have yet to see the impact in the much larger services sector.

Ø  Some central bank decision makers believe interest rates need to become positive in real terms, meaning that even the 5,000 year average of just under 5% may have to be breached.

Ø  Rapidly increasing rents will be reflected in CPI figures

Ø  The switch from globalization to reshoring and ‘friendshoring’ will increase manufacturing costs and therefore retail prices

Factors That Could Lower Inflation

Ø  As interest rates keep rising they are more likely to trigger a recession

Ø  The recession would involve job losses and lower earnings

Ø  The impact of rate rises is already being felt in the property market. US home sales fell 20% year on year in July while UK sales have fallen for five months. According to housing analyst Neal Hudson, K property prices were 17% overvalued in July but that could rise to 40% if mortgage rates reach 6%. 

Ø  As supply chains recover from pandemic dislocations there should be a downward impact on consumer prices.

Ø  The old adage that ‘the cure for higher prices is higher prices’ will come into play. We will stop making discretionary purchases if more of our budget goes on basics like food, rent and energy.

As ever, the question is what should we do about it as savvy investors trying to build and protect wealth? Watch my Wealth Week videos to learn more.