Fed's Experiments End, Normalization Begins

On my recent vacation in Mexico I struck up a conversation with another scuba diver who turned out to be a professor in economics. I asked him what he thought the odds were the Federal Reserve (Fed) could achieve a "soft landing", meaning slowing the economy down enough to control inflation while not causing a recession. He chuckled and said nobody really knows. This begs the question does the Fed really know? I don't think so.

Since 2020 the Fed has operated a series of economic experiments with no prior precedents. This put us in a sort of economic fog bank where we are effectively flying blind. Markets only recently started to adjust downward having realized the odds of a "soft landing" in a fog bank are not high. The good news is the Fed's experiments are winding down so the economic fog should clear. As more traditional (normal) Fed policies return, we should have better visibility of our economic future. Let's review a few of the Fed's failed Frankenstein creations.

Experiment #1 was Flexible Average Inflation Targeting. Previously the Fed attempted to stay ahead of inflation by acting to stop it as soon as possible. Its new idea was to average inflation. If inflation had been low for a number of years, then the Fed would allow inflation to run higher for a while. The highs and lows would "average" things out. Inflation was around 2% from 2012-2020. With this string of low inflation years as a starting point, the Fed first implemented its experiment in 2021. It stood by as inflation clocked in at 4% and kept rising. Eventually the Fed reacted, but not quick enough to stop inflation from peaking around 9%. Failed experiment #1.

In experiment #2 as a response to COVID, the Fed decided to stimulate the economy by increasing the amount of dollars in the system by about 40%. The Fed provided this money to Congress, which then used part of it to fund stimulus checks. The idea made sense, but its magnitude was way over the top. History tells us when governments put excessive new dollars into an economy it leads to inflation. This time proved no different. Many consumers were forced to use their "extra" stimulus money to offset inflated prices for food and energy. The stimulus money has since stopped flowing, but consumers are stuck with inflated prices. Failed experiment #2.

As these these experiments end, the economy will normalize and we need to adjust our expectations accordingly. Getting back to long term "normal" economics might look like inflation at 3%-4%, mortgages around 7%-8%, unemployment at 4%-5%, and economic growth of 2%-3%. Bond investors will benefit from higher interest payments. Equity investors will see falling corporate profit margins, less speculation on "story" stocks, and more focus on "boring" companies with stable profits that are less sensitive to economic cycles. The quicker we move through this normalization process, the sooner the economic fog clears. Clearer visibility will benefit investors who have their flight (investment) plans ready. Are your plans in place?                        

Frank Rizzo, CERTIFIED FINANCIAL PLANNER ^TM

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