The Fed & Inflation: Some Nuance

The Federal Reserve has been unreservedly steadfast in its commitment to get inflation under control. So far, they’ve raised the federal funds rate six times this year – for a total increase of 375 basis points just in 2022 – with a seventh increase likely in December. They’re clearly committed to their cause.

What’s less obvious is how much of this effort is working to bring down inflation now versus working with a lag, as well as how they’re going to resolve some tension between what they’re trying to achieve and their methods.

Yes, the Fed’s strategy is likely to bring down inflation, at least over time, but the markets and the economy are not set up to digest this degree of interest rate volatility. That level of volatility can have its own negative impacts.

Rate hikes alone may also fail to address all the underlying causes of inflation. For example, in energy markets, there’s a strong case that at least some of the inflation is coming from energy producers. The Fed’s actions won’t affect that side of the equation, and if the policy response begins to hinder production, that can potentially have a harmful impact itself.

In other words, there’s some medium- to long-term tension between the strategy and the desired outcome that still needs to be worked out.

In other areas, I do see some demand side improvement as it relates to inflation, e.g., commodity prices falling from their highs earlier this year.

For investors, this set of conditions reinforces the need to focus on companies that have a balance sheet that can work in pretty much any economic environment. Interest rates and inflation are important, but they can also be a distraction. If we do end up facing a sustained level of inflation, we want to own companies that have a lot of brand value, with pricing power, and zero risk of having a permanent loss. If that's not there, then I move on.

In other words, if a company with a strong balance sheet goes down 30% or 40%, I’m more likely to view that as an opportunity to buy at a discount rather than a genuine loss. There's a difference between paper losses and real losses, and a lot of that resides in the quality of the balance sheet.