The Week In Review: August 14-20

Markets were slowed quite a bit last week following the Federal Reserve’s release of minutes from its last meeting. There wasn’t anything super discouraging in them — but there also wasn’t anything overly encouraging either. This is where we are: We have made back about half of our losses from the market’s bottom in mid-June, mostly on the back of the market’s belief the Fed will ease up or curtail its rate-raising plans if the economy slows down. So far, the only bright spots in this slowing economy have been job growth and retail spending. Inflation talk has now shifted from last year’s “transitory” to this summer’s mot du jour “peak inflation,” meaning we’re at a point where we’re not going to see higher levels of inflation. That may be, but inflation is still at 8.5%, remaining unchanged in July as lower gas prices offset food and housing cost increases. (Gas prices have stopped dropping by the way, with the national average hovering around $4.)

If dropping gas prices are the catalyst that got us from 9.1% to 8.5% inflation, where will the rest of the inflation reduction come from? The government just passed another spending bill, which will not help lower inflation. Consumers are still spending but are depleting their savings and running up credit cards. There appears to be a ticking time bomb, and we cannot sustain this economy at “peak inflation” of 8.5%.

Sure, the Fed could simply say our new inflation target is 4% and make its job easier by letting the economy continue to slow. But all that would do is cement permanently a stagflationary environment, where a low- to negative-growth economy is dominated by elevated inflation. More likely, the Fed will be forced to continue raising rates through the rest of the year and maybe into next year to lower the inflation rate.

Remember when the benchmark 10-year Treasury rose to about 3.5% when we hit June lows? Currently the 10-year is around 3%. Since we’re at full employment, the Fed feels emboldened to allow unemployment to rise in an effort to lower demand. The problem with that approach is it takes a while for the momentum to build and also time for it to revert. You simply cannot dial up 5% unemployment from 3.5% and stop. If the job market falters, consumers will buy less and those with excessive credit card balances will be hurt by higher rates.

There you have it: lower inflation via demand destruction. With much of the U.S. economy driven by consumer spending, it’s hard to see how that doesn’t impact equity markets in a negative manner. Perhaps the market is starting to see some alternatives to the rosy picture it’s been painting for itself the past two months.