It is always better to invest, and predict that we will have high inflation from time to time. Like I wrote in a previous post from back in 05/2021 (published on substack 09/14/2022) There’s no downside to being prepared for inflation, and there’s plenty of upside to it.
I’m particularly afraid of inflation. If we have high inflation rates, and the public starts to believe they are going to be high for a while, long term rates will rise. If we have a recession or credit crisis during that time, the fed will have far limited tools available to help spur demand.
If we have inflation rates of say, 8%, and the public believes them to be here to stay, long term interest rates will have to compensate for that inflation belief. Otherwise, long term rates would indicate a negative interest rate. Even government bonds are subject to inflation risk.
Should a recession happen during a period of high interest rates, the fed’s ability to run the 2008 playbook is far limited. Why? If it makes sense that long term rates factor in inflation, how can the fed purchase bonds that push down rates in a way that does not further increase inflation? They could purchase bonds on the long end, and sell bonds held in their portfolio on the shorter end, but that has only so long of a runway. Currently the fed has roughly $4 trillion in bonds under 10 years.
From 2008-2015, the feds balance sheet grew by $3.5 trillion in assets. In Covid, the feds balance sheet increased $4.5 trillion. If the next crisis is bigger, using the 2008 playbook, new money would have to be created. Creating new money as well as lowering interest rates, are both inflationary forces. That limited runway could be a recipe for runaway inflation.
Am I saying we’re doomed if we get a recession in the midst of long-term rates? Of course not. For starters, recessions don’t always require intervention. Sometimes letting the free market work itself out is perfectly fine. Congress is also equipped with far more powerful tools than the federal reserve.
But we’ve come accustomed to the fed stepping up in a major way whenever we see trouble. Investors should be aware that the fed might not always be able to act.
All this is to say, I’m fine to sit back and watch a little disruption being caused by the fed’s rate increases. Inflation scares me far more.