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October 5, 2018

The Fed Takes way The Punch Bowel, Now What?

When it comes to throwing a “party,” the Federal Reserve can be an overbearing host. While investors are trying to enjoy themselves, he always worries about supply.
Is there too much or too little food? What if the alcohol runs out? He’s ready hours before the guests arrive, tweaking the lights and making last minute additions to the playlist.
When guests begin to arrive, the central bank sighs with relief. Nervously, he encourages conversation, introducing neighbors and work colleagues. More guests arrive, the wine is flowing, food is consumed and laughter rises out the windows.
But the Fed still can’t be happy. Are the guests getting too boisterous? Is the noise too loud? Will glassware get broken?
The host invariably decides that the party is getting out of hand. To encourage guests to leave, he removes the punchbowl.

The Party Gets Rowdy

“Removing the punchbowl,” of course, is the widely used metaphor for when the central bank reduces money supply by raising interest rates, to cool down a party (i.e., economic expansion) in danger of overheating and sparking inflation.
At first (post the 2008 financial meltdown), there was no party at all. No guests, no food, and certainly no merrymaking.
Consequently, the Fed decided to throw an economic get-together. Encourage friends to come out and enjoy. The central bank made the guest list, prepared the food and hoped for the best. 
This mirrors the Fed’s first decisions to lower interest rates in 2008. It hoped that lower rates would encourage increased borrowing from companies and individuals. The money spent would stimulate economic growth.
The last 10 years have been one of the best parties that the Fed has ever thrown. The music never got too loud, the guests felt tipsy but no one caused a scene. And so, without any major disruptions, the party continued at a perfectly acceptable pace. Until the revelry started to get excessive, in the form of higher inflation:

Recent data on inflation has the Fed wringing its hands. Like the over-anxious host, it is dealing with rising levels of inflation which require moving the proverbial punchbowl away from its guests.  
The informal definition of inflation is too many dollars chasing too scarce assets. The formal Webster version goes like this: “a general increase in prices and fall in the purchasing value of money.”
But the most important definition of inflation is that of the Federal Reserve’s, which reads like this:
Inflation occurs when the prices of goods and services increase over time. Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy.
Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes. A price index measures changes in the price of a group of goods and services. 
This long-winded and somewhat flimsy definition by the Fed carries the most weight because it is what drives the most influential bank in the world’s decisions on increases or decreases in interest rates. 
It’s not clear exactly what inflation data holds the most significance for the Fed. However, it is clear that most price data is heating up:
  1. Wage growth, a metric that has stayed stubbornly flat throughout most of the economic expansion, is now jumping. After several years of sub 2% growth, wages rose almost 3% in August.
  2. Part of this growth is due to increased minimum wages but part is due to less slack in the available labor pool. Recent labor reports show a dramatic drop in the percentage of people involuntarily working part-time (i.e., they would prefer a full-time job) or those discouraged in seeking employment because the prospects are so slim. Workers are finding it easier to demand higher wages and companies are having to lure new employees with higher pay.
  3. The Consumer Price Index (CPI) is widely regarded as one of the Fed’s favorite tools for measuring inflation. The last few months show a year-over-year change in the cost of living of about 2.8%. This is well above the Fed’s desired inflation rate of 2%.
  4. The impact of tariffs has yet to be captured in the CPI data. Tariffs are a form of taxation and they increase the price of many imported goods. It may take a few months before consumers feel the trade war’s affect on higher end prices, but the lift seems inevitable.
It’s harder to stretch your well-earned dollars when prices start rising, but investors have some options. As rates increase, risk-averse investors should shift more assets to income-generating vehicles. 
In the meantime, enjoy the festivities but get your Uber lined up.
Courtesy of Linda McDonough, Investing Daily (More from Investing Daily Here
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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