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How to get the Inflation Genie back in the Bottle

| February 21, 2023

Last week we discussed investor psychology and its effect on future market directions. Usually when people get overly optimistic, it typically points to a market that goes sideways or consolidates in some way. 

Inflation psychology works a little differently. When inflation is high, it tends to make people buy things sooner than they otherwise would, because they know prices will be higher in the future. Of course, that makes prices go even up, because demand is now higher (pulled forward).

When deflation is prevalent (prices going down), it causes consumers to push off purchasing items because they know prices will be lower in the future. But that makes demand go down, which pushes prices down even further.

It tends to be either an upward or downward spiral, depending on whether inflation or deflation is the trend at the moment.

So the Federal Reserve and Central Banks have decided that a “little bit” of inflation is a good thing. A little bit so that people will be compelled to buy, but not so much that demand gets out of hand. Deflation is generally seen as a bad thing by everyone except the guy who plans to buy a new TV in a year.

Unfortunately, the inflation genie is out of the bottle now and it’s proving difficult to get it back into that bottle (at least at the speed the FED would like). We’ve talked about 2% as that “magic” inflation number, but how did that come about? Keep in mind, that the average inflation rate since the Great Depression is roughly 3.25%. Some of us remember the 70s and 80s. Most of us remember the last 15 years after the Great Recession.

Take a look at the FED balance sheet after the COVID stimulus pushed monetary and fiscal policy through the roof (granted it had expanded significantly after the Great Recession).

That was $5 trillion that was added to the balance sheet (hint, it means someone owes that money).  Let’s look at what happened to the Federal government debt.

If you look closely, you can see that the national debt was somewhere around $23 trillion pre-pandemic and now is $31.5 trillion. If we add the national debt to the additional FED balance sheet debt, it’s a big number. But some of the FED balance sheet is represented in the national debt, so we don’t want to double count it. A good guess is somewhere around $7-$9 trillion was put into the economy to help support it when things were shut down. Much of that is shown in the M2 money supply. M2 represents money in checking and savings accounts plus money in circulation (coins and bills).


Roughly $6 trillion ended up in peoples’ accounts through various means. You can see that since the peak last March, the M2 balance has been going down and has officially turned negative year-over-year.

So that’s how the inflation genie got out of the bottle. Now the FED is fighting to get inflation down to 2%. But is there anything special about 2%? The answer is, “not really.” The quick reason it is there is because after the 2008 financial crisis and subsequent recession, it was difficult to get the inflation rate above 2%. So, the FED decided to explicitly use an inflation target of 2% (which previously was an implicit target). If you’re so inclined, you can read further about it here.

Remember, the only tools the FED can use is interest rates and monetary liquidity. They have been tightening them over the last year to reduce demand. Which really seemed to be working until longer-term interest rates dropped over the last few months. With that, financial conditions became easier, and activity began to pick up again.

Check out this headline from last week.

Airfare costs are up, lodging costs are up, and most service-related businesses are able to pass along higher prices to consumers. But this is in the face of rising debt.

On a related note, I was at the Seattle RV show over the weekend. Mainly as an exercise in seeing how many people are in the market for an RV (not me!). It was pretty busy, I would say. Many of the units had sold tags on them. But two things were interesting to me. The first is the prices of these were significantly off MSRP (10%-20%). The second needs some background. Walking into the nicest RV in the place, I saw there was a sold tag on it. I mentioned that to the salesperson, and he said, ‘Yeah it’s sold, but the buyers have to go get a HELOC to buy it’ (Home Equity Line of Credit). Now, this was a $400,000 RV that someone was buying (that they didn’t have the money for). A HELOC is likely somewhere in the 6%-8% range for most people. So, you’re going to buy a motorhome for $400,000 that you can’t afford to buy and use the equity in your home (which you will pay let’s say 7% on). That means you’re paying ~$2,300 a month in interest (just interest!) and that’s before you even drive it. Has anyone looked at the cost of diesel fuel lately? I don’t have to tell you how expensive it is to fill that tank up. Oh, and remember that it’s a depreciating asset!

I don’t know that person’s financial situation, but I might recommend they sit down with Andrew for some financial planning to see if they really can afford this.

This is just anecdotal, but it speaks to the demand that is still out there and it sounds like a lot of it is still fueled by debt.

So, in an effort to squash that demand, the FED is continuing to raise interest rates and the cost of borrowing. For people who have fixed their interest rates and can afford the payment, they’re fine. For those that have credit card debt or financing high ticket items that are depreciating, you may want to think twice. Below are the expectations for the next Federal Reserve meeting.  There is now a chance of a half point increase to short-term rates.

You can see a month ago, there was no chance of a half point increase. Things change fast.

Lastly, this is causing longer-term rates to increase. Here’s a chart of the 10-year treasury, which is perhaps the most influential rate in determining mortgage rates.

You can see that it is back to December levels at this point and may head back to the October highs. We are already seeing mortgage rates getting close to 7% again. That will likely slow demand for big ticket items. We will see. But until consumers run out of money or credit, this will persist. Getting the genie back in the bottle will take some more doing if you ask me, but having the Federal Government throw more fuel on the fire (more massive spending bills, however well-intentioned) is counter-productive for the FED’s goals.

I know this can get pretty heavy, and it is. It’s complex and changes fast. Hopefully you can grab a little from these blogs to help sort out some of the things going on in the economy. Have a great week. If you have any questions or want to talk through something, let’s talk.