Inflation Update 4.15.24

This week's inflation result came in higher than expected, signaling that inflation is still not under control. The Fed may have to keep rates higher for longer or even potentially raise rates further. Market participants need to understand what is driving inflation to properly navigate the market. 

US inflation is one of the most important topics influencing the Federal Reserve’s policy. Investors globally are eagerly waiting for the Fed to begin lowering rates, but inflation stands in the way. In this article I want to help readers understand why the Fed has been struggling to get inflation under control and to provide background on our current inflation environment.  

Key Inflation Drivers

Inflation has been a challenge globally since 2020. In the US, Inflation peaked at 9% in 2022. Most recently, inflation has picked back up reporting a 3.5% increase in consumer prices, potentially forcing the Federal Reserve to maintain rates higher for longer. Although the Fed has made a significant effort to quickly raise rates and reduced the pace of inflation, inflation is still not under control, and has the potential to climb higher. The problem is that the forces driving inflation are out of the Fed’s control. We sometimes do not give the Fed enough grace or credit for the work they have done to bring down inflation and contain issues during that process.  

In our current situation, geopolitics and supply-demand imbalances in commodities are key drivers of inflation. Given this backdrop, to fully solve inflation the Fed would have to literally end wars or fix commodity supply imbalances. Solving these types of issues is beyond anyone's control, let alone the Fed. Understanding this is crucial to navigating this environment.  

 The major geopolitical issues that are driving inflation today are 

• Russia / Ukraine War 
• Israel / Palestine War  
• US / China Trade War  

Key Inflation Themes 

• Rising Oil Prices 
• Rising Electricity Prices 
• Rising Uranium Prices 
• Rising Shipping Rates (shipping rates have more than tripled since its lows in 2023) 
• Rising Living Costs
• Rising Copper Prices 

When prices of raw materials and shipping rise, those increases are usually passed on to consumers which translates into rising inflation.  

With geopolitical tensions on the rise, I expect inflation to continue to trend higher. The current geopolitical tensions are disrupting supply chains and access to raw materials which translates into higher inflation. Also, strong demand for technology related raw materials and power will also continue to push prices of commodities and electricity higher.  

Why Does War Drive Inflation? 

When conflicts arise, trade disruptions are common, as well as restricted access to natural resources and blockages in exports or imports. These factors typically drive up prices for commodities and impact various industries. Understanding which commodities or industries will be affected by a specific conflict requires a deep dive into the economies and political situations of the involved parties, a topic beyond the scope of this article. However, it is crucial to note that ongoing conflicts are already causing disruptions in major global commodities, shipping routes, and supply chains, which inevitably contribute to higher global inflation. 

While the media has been emphasizing the Federal Reserve's potential rate cuts since the end of 2023, it often overlooks the persistent geopolitical risks to inflation. The Fed consistently communicates its openness to lowering interest rates but emphasizes vigilant monitoring of inflation risks. The Fed remains firm in its commitment to assessing inflation levels and ensuring they are manageable before considering rate cuts. This underscores the importance of considering not just domestic economic indicators but also global geopolitical factors in understanding the Fed's policy decisions. 

Portfolio Update 

In my recent trading activity, I have adjusted my portfolio to reflect a strategic shift based on my outlook for interest rates and inflation. Here is a summary of the trades I made and the rationale behind them: 

Sold positions in $LQD (US Corporate Bond ETF) and $FXY (Japanese Yen ETF): 

• These positions were based on the expectation of lower interest rates. 
• Higher interest rates could lead to selling in these positions. 

Replaced with positions in $TBT (Short US Treasury ETF) and $SQQQ (Short Nasdaq ETF): 

• Expect these positions to benefit from higher interest rates. 
• Betting on a continued trend of increasing inflation. 

My reasoning is that if inflation continues to rise, $TBT and $SQQQ will help offset short-term losses in my portfolio. Conversely, if inflation remains subdued, the rest of my portfolio should continue to perform, compensating for any losses from $TBT and $SQQQ. I plan to reassess my positions in $FXY and $LQD once there is a concrete improvement in the inflation outlook. 

Understanding Inflation

To help readers better understand inflation, I wanted to add a section about supply side vs demand side inflation. Understanding how these forms of inflation work is crucial to understanding our current inflationary environment.  

What Is Inflation 

Most people think inflation is solely about money printing. What people do not realize is that inflation represents the changes in prices of goods and services over a period. Of course, money printing plays a factor in driving inflation, but it is the change in prices of goods and services that dictate inflation results. Looking at inflation from this standpoint, it is important to understand that a variety of factors can drive the prices of goods and services higher, which in turn results in higher inflation. Furthermore, it is important to understand the difference between supply side and demand side inflation. The Fed cannot get inflation under control because central banks do not have tools to control supply side inflation, which is what we are experiencing.  

Supply Side vs Demand Side Inflation 

Understanding supply side vs demand side inflation is crucial to understanding what is driving inflation currently and why the Fed cannot get inflation under control.  

Demand Side Inflation 

Demand side inflation occurs when demand for goods and services exceeds the available supply. It is often associated with strong consumer confidence, elevated levels of disposable income, or government stimulus measures that increase spending. When demand is greater supply, businesses may respond by raising prices to maximize profits, leading to inflationary pressures. Demand side inflation can be caused by factors such as low interest rates, expansionary fiscal policy, or increased consumer and business spending. 

In simpler terms, imagine everyone suddenly wants to buy the newest smartphone, but there are not enough smartphones available. Because so many people want them, the stores can raise the price, and people are willing to pay more to get one. This happens when there is a lot of demand for something, but not enough of it to go around.  

Supply Side Inflation  

Supply-side inflation occurs when the cost of production increases, leading to higher prices for goods and services. This can be caused by factors such as rising production costs (e.g., wages, raw materials, energy), supply chain disruptions, or government regulations that increase the cost of doing business (e.g., taxes, tariffs). Supply-side inflation can also result from reduced supply due to natural disasters, geopolitical tensions, or other factors that constrain production capacity. In this case, prices rise not because of excess demand but because of decreased supply. 

Now, picture a situation where it costs more to make those smartphones. The materials used to make them become more expensive, or the workers who assemble them get a raise. As a result, companies that make smartphones must charge more for them to cover their costs. This happens when it becomes more expensive to produce goods, so the prices go up. 

In simple terms, demand-side inflation is like too many people chasing too few things, while supply-side inflation is like the cost of making things going up, so the prices go up too. Both situations can lead to higher prices, but they come from different reasons. 

Central Banks and Inflation 

When inflation gets out of hand, like we have seen in recent years, the central bank usually enacts policies that will slow down the economy which in turn will slow down the pace of inflation. The central bank can do many things to combat inflation like raising rates, reducing the Fed’s balance sheet, and decreasing the money supply. These tactics usually reduce business/consumer demand which in turn slows down the pace of inflation. If money becomes more expensive or harder to obtain, typically there will be less economic activity. This is sometimes called demand destruction. When it comes to supply side inflation the Fed really has no concrete tools, because supply side effects are out of its control. With its current policy, the Fed is hoping to slow down the consumer, labor market, and the overall economy. If the Fed can stop making people purchase goods and services at current prices, this will help bring down prices of various goods and services.  

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