How You Should Play the Fed’s Punch-Drunk Plan to Fight Inflation

|April 28, 2022

A year ago, the Fed had no plan to combat rising prices. Now they want the world to know they’ve got a plan to beat back what looks like increasingly sticky inflation because now their credibility is at stake.

That plan, which should be pre-set, steady, transparent, and formally announced as “forward guidance,” is instead going to be made up every six weeks when the Federal Open Market Committee (FOMC) meets.

Whether to raise the fed funds rate 25 basis points, 50 basis points, or 75 basis points (a basis point is one one-hundredth of a percentage point) at the FOMC’s upcoming May 3-4 meeting, or any subsequent meeting, isn’t set. And that is upending both stock and bond markets, and proof the Fed’s out of control.

The Fed raising rates isn’t going to kill inflation. There’s no way they could ever raise rates enough to kill it, and that gives us an opportunity.

Old Kind of Plan, New Kind of Inflation

The Fed’s kindergarten plan is to raise rates enough to dampen demand, slow economic growth, and eventually (and, they hope, quickly) reverse both inflationary expectations and rising prices.

That so-called plan reminds me of what Mike Tyson said when he heard what Evander Holyfield’s fight plan was before their title bout: “Everybody has a plan until they get punched in the mouth.”

Not only is the Fed going to get punched in the mouth by stubbornly high inflation, it’s going to get one-two punched in the gut by the stock market and the bond market if it raises rates too high too quickly.

The kind of inflation we’re facing isn’t your grandfather’s inflation. It isn’t the result of an oil shock, like in 1973-74 when the price of oil quadrupled, triggering the 1970s inflationary run. It isn’t because labor unions are strong and winning substantial pay hikes.

This inflation bout was primed by years of artificially manipulated low interest rates and insane Federal Reserve quantitative easing that ballooned its balance sheet to near $9 trillion. All it needed was a spark to light the fuse.

Then came 2020, the pandemic, the global shutdown, the factory closures, and the widespread and extraordinary supply chain disruptions, while, at the same time, trillions of dollars of stimulus checks were being helicopter-dropped across America so everyone could buy whatever was for sale.

The Fed raising interest rates isn’t going to cure COVID-19. Higher rates won’t solve supply chain issues. Or produce more semiconductor chips, or corn, wheat, soybeans, rice, beef, or oil. Raising rates won’t temper record wage growth. Higher rates will force workers to demand more pay, and they are.

On top of rising prices, wages are now rising, quickly. Not because unions are winning new contracts, but because of the Great Resignation. Because millions of people remain out of the workforce. Because there are more than two job openings for every one person re-entering the labor force. Because employers are desperate to fill open positions, and paying through the nose is the only way they’re attracting workers.

With more money in their pockets, consumers can pay higher prices.

The Cost of Changing Tides

We’re now an inflation nation with increasingly embedded consumer and producer inflationary expectations, with both consumers and producers possessing the wherewithal to absorb higher prices.

In the case of consumers, rising minimum wages and richer signing bonuses and perks – even for fast food workers, baristas, and Walmart workers – ensure their ability to at least keep up with rising prices. At the producer level, profit margins can be plumped up as rising input costs are passed along to consumers starting to stockpile goods they can afford now, knowing they’ll have to pay more later.

Raising interest rates from their artificially low level to where they’ll make a difference (where they’ll significantly dampen demand and force producers to lower prices) is a place too far for the Fed to get to.

The Fed can’t raise rates enough to get anywhere close to killing this inflation because, on the way there, they’ll kill the bond market and the stock market – crashing them so badly consumer confidence and investor risk tolerance would crater along with the economy.

The bond market would get hit where it’s most vulnerable, in the lowest tier of investment-grade bonds. Slightly more than 55% of all U.S. corporate-issued investment-grade bonds are rated BBB, the lowest investment grade possible. One level lower and your bonds are considered “junk.” The fact that so many companies’ bonds are rated BBB is a function of their creditworthiness, meaning their viability, cash flows, balance sheet leverage, and sustainability. If interest rates rise too high too quickly, most of these companies will have to refinance their maturing obligations at higher rates, which impacts their debt servicing ability and creditworthiness, meaning their ratings could quickly fall to junk status. That would create trillions of dollars’ worth of problems for companies and bond investors.

The Fed can’t afford to tank the bond market that way.

The equity values of companies subject to higher interest costs and lowered ratings in an economy engineered into a recession would tank.

Yes, I mean we would see the stock market crash from the weight of higher rates.

What’s to Be Done?

So, what’s the Fed going to be able to do? It’s going to be able to raise rates only enough to spook bond and stock markets, which will punch back by tanking and forcing the Fed to stop raising rates before America’s capital markets hit the canvas.

Whatever that level of higher rates turns out to be, it won’t be enough to tamp down inflation.

In the last great counterattack on inflation, which was running at 7.7% year-over-year from 1978 to 1979, at the same time the “prime rate” was 13% (end of September 1979), the Fed systematically shrunk the money supply and forced the prime rate up to a high of 21.5% on December 19, 1980. That level of rates ultimately killed inflation and set the stage for a multi-decade bond market rally.

What’s inflation running at now? 8.5% based on March’s CPI. What’s the prime rate now? It’s 3.5%. So, inflation is higher now than it was in 1979, and the prime rate is nine and a half percentage points lower.

The prime rate is an index of what big banks charge their best or prime customers to borrow. The accepted rule of thumb is the prime rate is the fed funds rate plus three percentage points.

Today fed funds (the rate big banks charge each other when they borrow overnight) are at 0.5%. When you add three percentage points to that, you get a prime rate of 3.5%.

The Takeaway: A Simple Stock Play

The Fed can’t raise rates too much, can’t raise the fed funds rate so high it jacks the prime rate up to more than twice what it is today. The bond market would crash, and so would stocks.

That means we’re likely to see the fed funds rate get up to maybe 3% before markets start to crack and the Fed reverses course.

However, the lack of a transparent and pre-set plan to raise rates is freaking out bond and stock investors and will continue to do so. Which creates an obvious opportunity for anyone who knows the Fed’s will be stymied in its efforts to raise rates enough to kill inflation.

Investors should buy big tech growth stocks with fortress balance sheets and pricing power on every dip caused by selloffs on rising rate fears. Because there’s going to come a time when the Fed’s going to have to announce they’re done raising or have to reverse course, and those quality growth stocks that have been beaten down are will lead the market back to new highs.

That’s a sober plan to play the Fed’s dilemma.