The Fed is Trapped
The Fed’s main policy tool for fighting inflation is to hike interest rates. This reduces the demand side of the economy by tightening credit conditions causing financial asset prices to decline which crimps investor savings and consumer demand and increases unemployment.
But raising interest rates does not stimulate commodity supplies like gold, copper, silver, nickel, lithium, cobalt, molybdenum. The core inflationary problem today metals demanded by the Green Economy. In fact, raising interest rates could have the opposite effect because it makes the cost of capital for investment in new commodity production higher.
After years of money printing and interest rate suppression, policy makers have created a historic speculative environment in financial assets. But now, the inflation genie is out of the bottle, and to restore its credibility, the Fed has no choice but to burst the bubble. At the same time, it is powerless to stop commodity inflation. To illustrate just how trapped the Fed is, it has never ended a hiking cycle with the Fed Funds Rate below CPI.
But the implied terminal rate in the Fed Funds Futures market is now just 2.9% in early 2023 while CPI is still at 8%. If the efficient market hypothesis holds, which it rarely does, CPI must drop precipitously over the next three quarters. Such is highly unlikely based on our commodity supply analysis shown above. There is a much bigger risk based on our work that inflation stays elevated, and the Fed ends up having to hike more and for longer than is currently priced in, as in all past tightening cycles.
Alternatively, there is the risk that the stock market correction continues under the existing planned increases and the Fed panics and ends its hiking cycle for the first time with real rates still in negative territory. In all cases, the market seems to be in state of delusion today with the average participant still buying the dip in overvalued tech, crypto, and fixed income assets, hoping for a return to those manias, while underestimating the risk of continued high inflation in valuable, scarce, tangible resources.
Crescat Capital
Monthly Research Letter
