What Is the Fed Doing? Portfolio Rescue 49

00:00:00.000 | Welcome back to Portfolio Rescue, where we always appreciate your comments, questions,

00:00:22.360 | feedback. Email us, askthecompoundshow@gmail.com. Duncan, today's Portfolio Rescue is sponsored

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00:00:47.120 | you have a question about financial planning, anything that's going on in your life, check

00:00:50.240 | it out, liftoffinvest.com. So, Duncan, back in 2010-ish, I was at a wedding of a friend,

00:00:56.200 | and a college buddy cornered me to talk about markets. And he had just discovered zero hedge,

00:01:01.720 | unfortunately for him. As one does. And was concerned about how the Fed's money printing

00:01:05.440 | is going to cause hyperinflation. And then he walked me through like a five-point plan

00:01:08.960 | of why this is happening, and why he's putting his entire portfolio into gold. And he talked

00:01:12.720 | his dad into doing the same. And honestly, some of the points at the time, it kind of

00:01:16.640 | felt like it made sense, right? That that same year, a group of well-known economists

00:01:21.760 | penned a letter to Ben Bernanke. It was an open letter, so you know it meant business.

00:01:24.880 | Open letter to Ben Bernanke. And I'm not going to name any names here, but it was well-known

00:01:29.680 | economists, portfolio managers, hedge fund managers, a lot of people you'd know. Really,

00:01:33.440 | really smart people. And they were begging him to stop QE, because it was going to cause

00:01:37.040 | really high inflation, maybe hyperinflation. And for someone who didn't know a lot about

00:01:41.600 | the inner workings of the Fed, because pre-2008, you didn't really have to. You know? Like,

00:01:46.280 | a lot of the stuff that they did in quantitative easing, and all this stuff they were doing,

00:01:51.880 | it was changed in 2008 in its aftermath. So, you know, before converting all my money into

00:01:57.600 | gold bars and buying cans of beans and creating a shelter in the backyard, like, I figured

00:02:02.600 | I might as well learn about this stuff. And one of the most informed sources I found in

00:02:05.960 | the Fed at the time was this blog called Pragmatic Capitalism from Cullen Roche. And so, Cullen

00:02:10.920 | had actually done the work, and he looked at what the Fed was actually doing, and not

00:02:14.520 | just saying, like, they're printing money. Because obviously at the time, the Fed was

00:02:18.880 | not handing money out. I didn't get any money from the Fed. My portfolio was not going up,

00:02:22.360 | because the Fed was giving me money. And it's like, people say the Fed is printing money,

00:02:25.200 | but where is it actually going? So, you had to kind of understand it. And Cullen kind

00:02:27.640 | of schooled me what was really happening, explained why hyperinflation was kind of a

00:02:31.400 | ridiculous concept to think about at the time, and why even high inflation after that was

00:02:35.440 | probably not going to happen, which turned out to be right. And so, after the latest

00:02:39.280 | crisis, like, we have elevated inflation now, so what's next? So, I wanted to get Cullen's

00:02:43.000 | perspective. So, today's show is going to be a little different. I put a bunch of questions

00:02:46.440 | together, because I'm kind of confused as to what the Fed is doing, and how this is

00:02:50.440 | going to all transpire, and what's going on. So, I wanted to hear Cullen. So, let's bring

00:02:53.760 | him out, John, just to talk about this current crisis. Cullen, how's it going, man? When

00:02:58.020 | did you start your blog? 2008-ish? Yeah, well, it was late 2008. Yeah, and it,

00:03:05.320 | God, it got really big really fast, because I was kind of, it was funny. I was actually

00:03:09.800 | writing in 2008-2009, I was actually writing content that was a lot like zero, I'd say

00:03:16.280 | zero hedge now, because everyone's been calling me that this year. But no, it was a lot like

00:03:20.880 | zero hedge, where it was kind of talking about all the sort of perma bear stuff that was,

00:03:26.640 | you know, unavoidable back then. But it was in that period that I really started to, especially

00:03:34.200 | in 2009-ish, really when things were starting to get really hairy with, especially with

00:03:40.000 | a lot of the central bank operations, and I was trying to navigate, you know, is this

00:03:43.920 | going to cause hyperinflation? That was the point where I was really delving deep into

00:03:49.840 | the operational side of everything, and really looking at it more from like the perspective

00:03:54.560 | of like an accountant, where I was trying to, you know, understand the flows of the

00:03:59.680 | balance sheets and the income statements, so that you can try to actually navigate.

00:04:02.960 | And that was the first thing that you said that made sense to me, like, you're talking

00:04:05.960 | about like, it's assets and liabilities, and they kind of cancel each other out, and that

00:04:09.240 | was the first thing that you said that made sense to me, like, oh, that's right, it's

00:04:11.880 | not like the Fed is flooding the system with money, this is more of like a banking transaction

00:04:15.880 | kind of thing.

00:04:16.520 | Yeah, well, you start to, when you actually go through the flow of funds, you realize

00:04:20.560 | that almost everything that's done with quantitative easing is after the fact of fiscal policy.

00:04:26.980 | So there has to be treasury bonds that were issued in the first place in order for the

00:04:32.040 | Fed to even buy the treasury bonds.

00:04:34.160 | So, you know, the way to think of it is like, if you were to consolidate the Fed into the

00:04:38.440 | treasury, well, in that case, you know, what QE really does is QE is basically issuance

00:04:45.520 | of a deficit in cash form.

00:04:49.080 | It just takes you to that ultimate form of the government actually does print the money.

00:04:54.560 | But what QE is, QE is weird, because if the treasury bonds were already printed, and you

00:05:01.120 | could say that a deficit is basically government spending that results in a deficit is technically

00:05:07.040 | treasury bond printing.

00:05:08.520 | Like I think that's a fine term to use as far as deficit spending goes.

00:05:12.720 | But all QE does is then take that bond and swap it with a reserve in the private sector.

00:05:17.560 | And so it's the exact same thing as if the government, the treasury had in the first

00:05:21.920 | instance just printed the reserves into existence.

00:05:25.480 | And so to me, when you look at what QE does, you're like, well, wait a minute, this is

00:05:29.640 | just it's really just an asset swap.

00:05:31.520 | And maybe this has all sorts of like tangential impacts.

00:05:34.840 | You can debate whether that makes people go out and need to replace their cash with high

00:05:39.880 | yield bonds.

00:05:40.880 | And there's a risk component there, for sure.

00:05:44.200 | It's not technically money printing in the sense that like, you know, taking wheelbarrows

00:05:48.480 | of cash out of the treasury would be in dumping them on the street, you know.

00:05:52.160 | And now we're looking at the other thing where it's QT, which is quantitative tightening.

00:05:54.960 | So I put together some questions here.

00:05:57.720 | These questions may be a little leading because I've shared some thoughts on the Fed, but

00:06:00.800 | I wanted to hear your perspective on this.

00:06:02.280 | So Duncan, let's do the first one.

00:06:03.520 | These are all questions for me, because I have a lot of questions about the Fed, too.

00:06:06.040 | Let's do it.

00:06:07.040 | I like they're all short and sweet, you know, and not a single not to brag in here.

00:06:11.960 | No, I'm kidding.

00:06:13.720 | We love those.

00:06:14.720 | All right.

00:06:15.720 | Up first, is the Fed making a huge mistake by potentially throwing us into a recession?

00:06:19.440 | This is a question everyone has now.

00:06:21.120 | Yeah.

00:06:22.120 | So listen, Cullen, obviously the Fed had to do something.

00:06:24.200 | Like, you can't just let inflation be at 8% or 9%, and it seems like the government

00:06:27.580 | is not really doing anything, even though they are the ones who spend a bunch of money.

00:06:30.520 | So I guess my biggest surprise is not that the Fed is raising rates, but it's the speed

00:06:34.640 | at which they're doing it and the fact that they seem to be willing to throw us into a

00:06:38.120 | recession to get there.

00:06:39.320 | So do you think that there is a mistake here in terms of the magnitude of this move and

00:06:43.280 | the fact that maybe they're trying to make up for mistakes they made in the past by not

00:06:46.880 | finding that, you know, it's not seeing that inflationary spike in the first place?

00:06:50.600 | Yeah.

00:06:51.600 | And I, you know, I think being in the financial markets, that's the thing.

00:06:54.880 | That's the difference in the way we perceive things versus the way the Fed does.

00:06:57.980 | I mean, we're inherently focused on risk management to a large degree.

00:07:02.660 | And so to me, you know, the pace of these rate hikes, it's the fastest rate hikes basically

00:07:08.180 | ever.

00:07:09.180 | The market is already pricing in four, four and a half percent overnight rates.

00:07:13.460 | So we've come basically off of zero to four and a half, which, you know, from the basis

00:07:18.380 | of zero, that's a huge, huge historical move, much bigger than anything that's ever happened

00:07:23.780 | before.

00:07:24.780 | And so the portfolio shock and the economic shock is really only just filtering through

00:07:30.060 | the system.

00:07:31.060 | Because, I mean, it was just a year ago, literally a year ago, that Powell was talking about

00:07:35.860 | the markets and saying, we don't need to raise rates yet because the unemployment rate is

00:07:40.460 | still too high.

00:07:41.460 | That was only a year ago.

00:07:43.540 | So they hadn't even really started to move as of 12 months ago.

00:07:47.560 | And so they're really, they're playing, you know, catch up here in a big way.

00:07:51.780 | The worry now, this feels a lot like sort of the opposite environment where, you know,

00:07:56.620 | the big thing that I look at is not only the foreign exchange markets where you see the

00:08:01.500 | dollar going crazy, which is almost always a sign of bad stuff going on in foreign markets.

00:08:06.140 | But if you look domestically, the mortgage rates in the United States, you know, have

00:08:12.300 | surged so much that at some point you have to look at this and say, OK, housing is the

00:08:17.540 | biggest sector of the U.S. economy.

00:08:19.660 | If you if you bring housing to a complete freeze, what happens to the U.S. economy?

00:08:25.460 | And we know from 2008, 2009, if you cause a big problem in housing, you could cause

00:08:30.420 | a big problem in the aggregate economy.

00:08:32.500 | So that is the risk that I'm growing increasingly concerned about.

00:08:35.780 | And you look at all this housing data, all the housing data is starting to look like

00:08:39.620 | a disaster.

00:08:40.900 | And I don't see how with mortgage rates at 7 percent for, you know, the next 12 months,

00:08:46.420 | how does that not just continue for all the 24 months?

00:08:48.700 | I got I got a question come up on housing.

00:08:50.980 | I just want to ask.

00:08:51.980 | So I've looked at this before.

00:08:53.220 | Every time inflation has spiked above 5 percent in the past, the only way it's come down is

00:08:56.740 | is through a recession, basically.

00:08:58.740 | Do you think that the Fed has just resigned to this?

00:09:01.020 | Like, it seems like they almost don't even want to look for another path.

00:09:04.140 | Like, is there a way that we could get inflation come down and be a little more patient and

00:09:08.260 | bring it down without a recession?

00:09:09.740 | Is that pretty much the only tool they have?

00:09:11.500 | Yeah.

00:09:12.500 | I mean, a lot of this is in my view, it's sort of the way a boom bust cycle works, like

00:09:17.140 | you could look back at 2021 and say, well, the market just it went up too much.

00:09:22.140 | Like people were were at home, bored, doing stupid stuff, buying more stuff than they

00:09:26.700 | should have, you know, buying GameStop and AMC and all these silly things that, you know,

00:09:31.500 | were kind of going on last year.

00:09:33.380 | And so you had this big sort of irrational boom.

00:09:35.460 | And I think it's it's perfectly rational to argue now that there needed to be some give

00:09:39.500 | back.

00:09:40.500 | So there needed to be a bust to some degree.

00:09:41.940 | And, you know, whether that results in like a technical recession or not, you know, it's

00:09:45.380 | just that's just the way.

00:09:46.980 | And my thinking is in the economy sometimes evolves.

00:09:50.020 | The worry with me now is that I basically think that you were going to get this bust

00:09:55.860 | no matter what.

00:09:56.860 | Right.

00:09:57.860 | Because that's just the way that the cycle was going to occur.

00:10:00.300 | You know, you had so many unusual variables from covid that these variables were eventually

00:10:04.940 | going to work themselves out.

00:10:06.180 | It was just it's really just a matter of time.

00:10:08.260 | I mean, the you know, the Fed was was wrong to call this transitory.

00:10:12.300 | But in the long run, the likelihood that this ends up being transitory is probably very,

00:10:17.100 | very close to right.

00:10:18.220 | So the worry now is that the car is slowing and you start to see this already in a lot

00:10:25.020 | of the data and the Fed is coming in and they're basically slamming the brakes on.

00:10:30.900 | And so now you worry, well, are they causing the car to slow to a speed that's unnecessarily

00:10:36.900 | slow or are they potentially going to cause the car to crash at this point?

00:10:40.700 | Because they're they're now being trying to be proactive about something that was already

00:10:45.820 | well in motion.

00:10:46.820 | Right.

00:10:47.820 | To your point, like, I think everything spikes so much.

00:10:50.420 | It's like a retail sales charts.

00:10:51.680 | All these things are off the charts.

00:10:52.820 | Even a normalization probably would have felt or looked like a slowdown.

00:10:56.180 | Yeah.

00:10:57.180 | So, yeah.

00:10:58.180 | With or without them.

00:10:59.180 | So let's I wanted to kind of talk about like the unintended consequences.

00:11:00.380 | Duncan, throw up the next question.

00:11:01.900 | All right.

00:11:02.900 | Yeah.

00:11:03.900 | You're already kind of segwaying nicely into this.

00:11:05.540 | But yeah.

00:11:06.540 | What are some of the unintended consequences of the Fed raising rates so aggressively?

00:11:09.820 | So you mentioned the dollar here.

00:11:11.620 | I think that's the biggest one right now where sometimes the Fed can't help like what their

00:11:16.740 | actions have in the rest of the world.

00:11:18.180 | But should they care if the dollar strengthening is going to mess up a bunch of emerging markets

00:11:22.500 | and even some developed markets like the UK, where the strength of the dollar is potentially

00:11:26.980 | creating crises elsewhere in the world and eventually that comes to our shore and then

00:11:30.860 | they're forced to fix.

00:11:31.860 | So like, should they care about that stuff?

00:11:34.440 | They end up being forced to care at some point, because if things get bad enough abroad, the

00:11:39.780 | especially with the European banking system, it's so intertwined into the U.S. banking

00:11:44.740 | system that, you know, let's say that let's play sort of like worst case scenario here

00:11:50.340 | and say that Europe gets really messy in the next two years.

00:11:54.300 | And let's say that Credit Suisse and Deutsche Bank and a lot of the big European banks are

00:11:58.340 | legitimately in big, big trouble.

00:12:00.980 | Well, one of the central banks that has to get involved in all of that is the Fed, because

00:12:06.100 | the Fed is so intertwined in the European banking system through like the, you know,

00:12:09.980 | the euro dollar market, basically euro or dollar denominated borrowing markets that

00:12:15.100 | are based in Europe.

00:12:17.300 | The Fed ends up being forced to get involved through, you know, Fed swap lines or lending

00:12:22.940 | facilities to these entities.

00:12:25.140 | So to me, it's kind of unavoidable.

00:12:27.700 | And that's the, you know, it's technically like a Triffin dilemma, basically, where the

00:12:33.820 | Fed is they're the reserve currency issuer in the world.

00:12:39.100 | And the U.S. economy is so big and so intertwined into everything else that there's a lot of

00:12:43.420 | there's a lot of markets that rely on the dollar to function, a lot of foreign economies

00:12:48.060 | that rely on the dollar to function well.

00:12:50.420 | And so when the dollar goes up like it is, you know, because mainly because credit markets

00:12:55.660 | are becoming so much more expensive, it's becoming more expensive to get dollars.

00:12:59.100 | So the demand for dollars is now, you know, rising and rising.

00:13:03.100 | You get this knock on effect where it comes back to our shores in a way where you slow

00:13:07.260 | down everything else and the Fed ends up having to get involved because eventually it causes

00:13:12.180 | a slowdown in the United States.

00:13:14.660 | So you've got kind of a double whammy here where the Fed is at risk of not only, I think,

00:13:21.100 | potentially causing a much or contributing to a much bigger slowdown in foreign markets,

00:13:25.060 | but you've got the domestic impact where are they actually managing the risks of the of

00:13:30.940 | the credit markets in the United States and, you know, really looking at this in a proactive

00:13:36.740 | manner where they're they're really managing the potential for something that starts to

00:13:42.740 | look a little bit like 2008 here in the next 12 to 24 months.

00:13:47.340 | I don't want to just keep dunking on perm bears today, but remember when the dollar

00:13:50.580 | was going to collapse to that was another hyperinflation thing and the dollar is just

00:13:53.460 | stronger than ever.

00:13:54.780 | I think today maybe people will say it's like the cleanest shirt in the laundry hamper.

00:13:58.380 | But the next you mentioned housing, I want to get into that.

00:14:01.460 | So Duncan, do the next question, because I think this is I think to me this is the biggest

00:14:04.340 | unintended consequence for the United States right now.

00:14:07.260 | OK, what is going to happen in the housing market now that mortgage rates are 7% and

00:14:11.780 | prices are up about 50% since the start of the pandemic?

00:14:15.140 | John, throw the chart up here of housing as a percentage of GDP.

00:14:17.940 | So this is from John Burns Real Estate Consulting, and they show that over time, historically,

00:14:22.300 | the housing market as a percentage of GDP.

00:14:24.260 | So this is everything.

00:14:25.780 | Housing costs, utilities, furniture repairs, maintenance, construction, all this stuff.

00:14:28.860 | I think it's kind of hard to remember that there's so much that goes on with the transaction.

00:14:34.260 | Not only the transactions where we have realtors, inspectors, loan officers, appraisers, movers.

00:14:38.060 | I got an email this morning actually from a loan officer saying it's like tumbleweeds

00:14:42.540 | right now because, you know, they were living off of refinancing for years.

00:14:45.700 | He's like, we're 100% based on commission.

00:14:48.700 | He's like, our office is basically screwed.

00:14:50.640 | There's no transactions going on right now.

00:14:52.740 | And so you also have the construction industry and the housing supply in the future.

00:14:56.220 | And so obviously, like inflation, housing was not healthy in 2020 and 2021.

00:15:02.100 | But this is not healthy either, where you've seen prices go up so much, incomes haven't

00:15:06.220 | kept up, and now rates double.

00:15:09.340 | Prices would have to fall 40% or 50% to make these rates make sense, right, from a payment

00:15:14.300 | perspective.

00:15:15.300 | I just don't see how this shakes out and how just, again, slamming the brakes on an industry

00:15:19.300 | like this that's this big and this important, I don't see how that ends well at some point.

00:15:24.380 | I think this is the thing that the average listener is most panicked about too, based

00:15:28.140 | on like the questions we get, it's the housing element.

00:15:31.100 | Yeah.

00:15:32.100 | And it's like Ben was alluding to, it's a really, really big, important, I mean, there's

00:15:38.620 | entire economic research on the idea, the theory that housing is the economy essentially.

00:15:44.580 | And so when you bring that sector, it's such a big component of fixed private investment,

00:15:49.740 | which is a huge component of GDP, arguably the most important component of GDP.

00:15:55.400 | When you bring that sector to a freeze, I mean, the knock-on effect is huge.

00:16:00.660 | And it's not just the knock-on effect is specifically in the real estate industry, because obviously,

00:16:06.740 | you potentially put a lot of mortgage bankers out of business, you put a lot of real estate

00:16:10.420 | brokers out of business, you halt new construction.

00:16:13.300 | But this filters through all of the credit markets as well.

00:16:15.900 | And that was the lesson from 2008 that I think really scared everybody was that it was, hey,

00:16:21.960 | when this asset price falls by 20 or 30%, that has a huge knock-on effect on everyone

00:16:28.740 | else's balance sheet.

00:16:29.860 | And that caused the entire credit quality of really the entire balance sheet of the

00:16:35.220 | private sector, and especially the household sector to basically collapse on itself.

00:16:40.460 | And that's the thing, I'm not, I think Ben's written about this too, I'm not in the 2008

00:16:46.700 | camp where there's a lot of differences between this and 2008, especially from the credit

00:16:51.100 | quality side of the borrowers who have been buying homes lately.

00:16:54.500 | Yeah, the loans people took out, they had much better credit quality.

00:16:57.940 | The people have already locked in low rates.

00:17:00.100 | It's not like they have these teaser arms that are going to reset at higher rates.

00:17:03.540 | So from that perspective, the people that own homes are in a much better position.

00:17:07.140 | But I just think-

00:17:08.140 | But it's still, here's the thing that scares me about this is that when you look at the

00:17:11.620 | price increase from the pre-COVID period, you're starting to see this with a lot of

00:17:17.900 | the sort of pre-COVID irrationality in some of the other markets where they're just reverting

00:17:22.980 | right back to where they were basically.

00:17:24.700 | Like everyone's basically just repricing all this stuff saying, "Oh, that was a fun game.

00:17:29.740 | That was kind of a dream, and we're now reverting right back to where we were pre-COVID."

00:17:34.420 | You could look at housing and make a really strong argument that that is a pretty rational

00:17:38.260 | position.

00:17:39.260 | I mean, disposable income is only up like 15% since the pre-COVID period.

00:17:42.580 | Well, here, John, throw Cullen's chart up here from disposable income.

00:17:47.000 | So you have this chart of disposable income to housing prices.

00:17:49.300 | And again, the thing that worries me is not that this didn't have to get fixed eventually,

00:17:53.320 | it's the speed of it happening.

00:17:54.320 | And I feel like people haven't taken the time to realize how this is going to filter through

00:17:58.220 | because it happened so- I mean, rates were 3% at the beginning of the year.

00:18:01.820 | Now they're 7% and change, and it happened seemingly in the blink of an eye.

00:18:06.660 | And that's the thing that I think from the Fed's perspective is somewhat reckless here

00:18:11.700 | is that this takes a really long time to filter through the economy.

00:18:16.380 | Housing is a really big slow-moving beast.

00:18:18.540 | And I mean, I remember 2006 when housing technically peaked, the yield curve was inverting, and

00:18:24.340 | it took 18 to 24 months.

00:18:25.660 | I mean, you could have sat around and made bullish arguments about the U.S. economy for

00:18:30.500 | two years before that really started to materialize into something that was a noticeably really

00:18:37.220 | frightening event.

00:18:38.760 | And that's the thing.

00:18:39.760 | I mean, Fed policy works notoriously with a lag.

00:18:42.260 | I mean, Milton Friedman wrote a famous paper about this 50 years ago, and yet we're still

00:18:48.540 | willing to ignore not only the signs of inflation that were there last year, but now the signs

00:18:55.700 | of potential deflation across so many different sectors.

00:18:59.180 | And the Fed is just looking at this stuff and saying, well, we need to keep the pedal

00:19:05.300 | to the metal here until we crash this car, and just ignore any of the potential risks

00:19:11.700 | that are happening in sectors that can cause really, really big asymmetric downturns.

00:19:16.300 | Right.

00:19:17.300 | They seem to want it to happen very quickly.

00:19:19.340 | So I think, I mean, if anything in the last 15 years has taught us is that inflation is

00:19:23.580 | hard to understand.

00:19:24.580 | So Duncan, do the next question, because I think this is important.

00:19:27.420 | Our understanding of inflation, to me, seems like ... The Fed obviously doesn't get it.

00:19:31.500 | I think a lot of people don't.

00:19:32.500 | So Duncan, go ahead with this one.

00:19:33.500 | Yeah.

00:19:34.500 | Okay.

00:19:35.500 | Is it possible that we simply don't understand enough about inflation to use monetary policy

00:19:39.100 | as the only way to slow it down?

00:19:40.940 | Because, I mean, obviously it's easy to dunk on the Fed now and say they missed the inflationary

00:19:44.980 | spike because they were still putting the gas pedal on a year ago.

00:19:49.820 | But I think a lot of us don't.

00:19:50.820 | So it's easy now to go through, and we have so many good macroeconomic thinkers that you

00:19:54.780 | can go to the BLS website and look at each single component and then how it's calculated.

00:19:58.600 | You can go through all this stuff, owner equivalent rent, and look at all these different things

00:20:01.420 | and understand what the pieces are doing to inflation.

00:20:04.860 | But I still feel like we don't really understand the levers to pull and how it's going to impact

00:20:09.540 | inflation in terms of monetary policy versus fiscal policy versus what happened with the

00:20:13.580 | pandemic.

00:20:14.620 | All these things helped cause inflation, but we don't have ... You can't say fiscal policy

00:20:19.300 | caused 43% of it and monetary policy caused 13.

00:20:22.500 | So I think that's the hard part for them is that, first of all, the Fed seems to be the

00:20:26.540 | only one that's trying to do something about inflation, and we don't know if their policies

00:20:31.420 | can do it or how long it is going to take besides throwing us into a recession.

00:20:35.580 | Yeah.

00:20:36.580 | I mean, and that's my big ... I mean, I've spent most of my adult life studying inflation

00:20:42.380 | because I basically think inflation is the most ... I mean, if you're looking at portfolio

00:20:46.220 | management, in my opinion, understanding inflation is probably the most important component of

00:20:51.860 | the whole construction, portfolio construction process.

00:20:55.740 | And I always tell people, I still don't understand inflation.

00:21:00.820 | Inflation is so confusing.

00:21:02.020 | It's so dependent on specific economies and the way that things are actually functioning

00:21:07.820 | in certain environments.

00:21:09.220 | Every environment's different.

00:21:10.260 | Every economy's different.

00:21:11.820 | Every policy response is different.

00:21:13.340 | So there are infinite numbers of variables that go into the contributing factors of inflation.

00:21:21.180 | And I think, I mean, the last two years are a perfect example of even the smartest people

00:21:25.460 | who study this stuff, they don't really have anything remotely close to a precise metric

00:21:30.140 | for understanding what is the causality even.

00:21:33.060 | Right.

00:21:34.060 | There's no model for this, right?

00:21:35.060 | That you can say, like, if we take these three inputs, put them in here, that's going to

00:21:37.740 | tell us what inflation is probably going to be.

00:21:39.700 | No one knows this stuff.

00:21:41.140 | Yeah.

00:21:42.140 | And that's the worrisome thing is that I'm ... if anything, studying inflation is just

00:21:46.980 | really humbling.

00:21:48.860 | It'll teach you that you really don't ... you don't know what you don't know.

00:21:53.300 | And so that's the component where I'm always sort of worried about the tail risk, the asymmetric

00:22:00.540 | risk in all of this, where, okay, well, what if we get this wrong?

00:22:06.180 | You end up getting it wrong in a big, big way, in a way that causes a lot more collateral

00:22:11.580 | damage.

00:22:12.580 | And to me, that's sort of the most important debate that's going on right now, is it, is

00:22:16.980 | this 1978 or is this more like 2008?

00:22:20.300 | And to me, there's just, there's not a lot about what's going on today that looks like

00:22:24.940 | the 70s to me.

00:22:25.940 | You could maybe make the argument that like the stuff going on with oil and Russia, you

00:22:29.940 | know, is a little bit kind of reminiscent of like the 70s.

00:22:32.940 | But aside from that, there's a lot of big underlying trends that this feels more, more

00:22:41.300 | closely aligned to a potential 2008 type of credit event rather than a sort of stagflation,

00:22:49.540 | permanent high inflationary event.

00:22:51.420 | So I don't, maybe I'm wrong.

00:22:52.820 | I mean, I'm not, I'm, I'm not arrogant enough to say that.

00:22:56.140 | Well, I mean, the thing is, we love these, we love these analogies because ...

00:22:59.300 | Towards like an '08.

00:23:00.740 | Yeah.

00:23:01.740 | So these analogies are fun because it makes it, you feel more comfortable that you know

00:23:04.380 | how it's going to end.

00:23:05.380 | So I've been using like the World War II analogy where we had this huge spending come in and

00:23:08.700 | then you get this huge inflationary spike and then it, I mean, back then it got to like

00:23:12.080 | 20%.

00:23:13.080 | Obviously that was a much different, it felt like wartime spending for the pandemic.

00:23:16.260 | But that's the hard thing is, is you could take little bits and pieces from each analogy

00:23:20.180 | and it's this, this beast just feels completely different because of what happened and, and

00:23:24.500 | the government response.

00:23:25.500 | So you talk about like collateral damage.

00:23:27.100 | So Duncan, do the next one.

00:23:28.100 | Because I think this, this one to me is the one that's been hard to wrap my head around

00:23:30.740 | lately for how economists are viewing this.

00:23:33.140 | Yeah.

00:23:34.140 | And you and Michael talked about this on Animal Spirits, so yeah, people check that out if

00:23:38.460 | you didn't see it.

00:23:39.460 | Why does it feel like economists are cheering for people to lose their jobs right now?

00:23:43.340 | Why are workers the ones being blamed for inflation?

00:23:45.660 | No, I know that economists try to sort of detach themselves and not be emotional, but

00:23:51.060 | you know, I would love it if we could figure out a way to, to not say we have to have the

00:23:54.700 | unemployment rate go from 3.5 to 4.5 and have a million people lose their jobs to just so

00:23:59.620 | we can get, bring price stability down because my thinking is, okay, the Fed has a dual mandate.

00:24:03.540 | It's price stability and it's employment, right?

00:24:06.660 | And so it seems like for a while right after the pandemic, the only thing they cared about

00:24:10.660 | was unemployment, right?

00:24:12.660 | And now the only thing they care about is inflation.

00:24:14.700 | I guess that's my problem with what they're doing is, there doesn't seem to be a lot of

00:24:17.540 | balance and they're just, they're focusing on the extremes and that, that makes like

00:24:21.260 | things go back and forth and back and forth and the pendulum is swinging.

00:24:24.500 | And so, I don't know, isn't, wouldn't it be nice if we could find a way to balance things

00:24:27.420 | out and maybe try to let inflation cool a little bit without a bunch of people having

00:24:30.700 | to lose their jobs?

00:24:31.700 | I know recessions are part of the, you know, that's the system we live in.

00:24:34.500 | Like recessions are going to happen, but I guess my way of thinking is I would prefer

00:24:38.300 | not to have one if we don't have to.

00:24:39.900 | Yeah.

00:24:40.900 | Yeah.

00:24:41.900 | I mean, that's the, you're kind of going back to what we were talking about before the,

00:24:44.780 | you know, the ebb and flow of all this stuff where, you know, some variance is natural.

00:24:49.340 | Obviously, you know, people do stupid stuff.

00:24:51.860 | You get, you know, booms and busts along the way.

00:24:54.560 | The question is, is do a lot of these policies exacerbate the booms and the busts, you know,

00:25:00.740 | across, you know, the spectrum of time.

00:25:03.580 | And that's the, that's the hardest variable to manage in all this because the Fed is,

00:25:07.620 | you know, the Feds now, they're super worried about having made the mistake that they did

00:25:13.020 | last year.

00:25:14.020 | And I think now they're trying to play catch up, but now they're potentially operating

00:25:17.380 | such an impatient manner where the risk of them now creating the opposite, you know,

00:25:23.740 | mistake is increasing.

00:25:25.180 | And so, you know, I think inevitably there is, you know, to some degree there's a give

00:25:31.240 | and take in terms of, you know, can you, can you have permanent low inflation and permanent

00:25:36.020 | low unemployment?

00:25:37.020 | No, there's going to be some ebb and flow in the way that the business cycle works.

00:25:41.780 | That's just, you know, a natural part of the way the economy works.

00:25:44.740 | The question is, is, you know, how much does that need to, do those variables need to actually

00:25:49.580 | gyrate over time?

00:25:50.740 | And I think, I think we're going to come out of this period and I think people are going

00:25:54.780 | to look back at the way the Fed managed interest rates and say, you know, is this the right

00:25:59.300 | way to be doing this going forward?

00:26:01.640 | Because I think that the discretionary manner in which they're sort of just shifting the

00:26:05.820 | car into, you know, reverse in sixth gear, as if like, there is no like one, two, three,

00:26:11.860 | four or five gear in between all of that is a worrisome.

00:26:16.660 | And obviously, you know, with the benefit of hindsight, we can look back and say, these

00:26:21.980 | people are not very good at this, you know, and I'm not bad mouthing Jerome Powell necessarily.

00:26:28.060 | I don't necessarily think anybody would be good at it.

00:26:30.620 | And that's kind of, I think, one of the big lessons coming out of this.

00:26:34.060 | It's easy to play armchair Federal Reserve Chairman.

00:26:36.020 | So Duncan, do the last one because we'll put our own skin in the game here.

00:26:38.980 | Okay.

00:26:39.980 | Yeah.

00:26:40.980 | And I want to throw a disclaimer on this one.

00:26:41.980 | Keep in mind that we are policy influencers.

00:26:44.180 | And so we have people on the Hill watching who are making policy based on what we talk

00:26:48.140 | about here.

00:26:49.140 | So, you know, it's a lot of responsibility.

00:26:52.900 | What would you do if you were running the Fed right now?

00:26:55.020 | So obviously, like, this is not a job that I would want because there's so much pressure.

00:26:59.860 | And I think one of the big mistakes they made is this just I think this is just natural

00:27:03.340 | because of the way the free flow of information.

00:27:05.020 | I think that the Fed is talking way too much these days.

00:27:07.300 | I think they say too much.

00:27:09.000 | And I think part of them kind of likes the power they have that they hold.

00:27:12.900 | And remember, back in the day, people were looking at Alan Greenspan's briefcase to see

00:27:16.140 | if it's if it's thick, he's going to do something, if it's thin, he's not going to do something.

00:27:19.100 | Now the Fed, there's a Fed statement every day, it seems like.

00:27:22.700 | And they talk and the market moves, and I feel like they kind of enjoy that power a

00:27:26.220 | little bit.

00:27:27.220 | And they're human, so who can blame them?

00:27:28.700 | But I just think, to your point about things working on a lag, I think especially with

00:27:32.640 | Treasury rates at four to five percent coming from zero, in mortgage rates at seven coming

00:27:36.720 | from three in such a short period of time, now's a great time to just take a breath and

00:27:41.020 | let's just see what happens.

00:27:42.700 | It's not you could say if inflation stays high, we're going to we're going to use that

00:27:46.260 | data and five or six months down the line, we'll we'll raise again if inflation stays

00:27:50.060 | high.

00:27:51.060 | I think it's a great way to show a little patience here, that that'd be the thing that

00:27:53.300 | I would look.

00:27:54.340 | Stocks and bonds have already crashed, housing prices are rolling over.

00:27:57.140 | My point is, like, what's the rush here?

00:27:59.180 | Why?

00:28:00.180 | It's because it's going to take some time, regardless of how it happens.

00:28:03.220 | Yeah, I mean, I've got I, I got up and left DC 15 years ago, moved to the beach in California.

00:28:12.180 | So you know, I, I always joke around that.

00:28:15.300 | I think everyone at the FOMC, everyone in the Federal Reserve should do something similar.

00:28:19.580 | Like, you know, get up, leave, fire yourself.

00:28:23.180 | And I mean, you could set you could easily set interest rates on I mean, there's some

00:28:27.740 | theories that say, hey, the the overnight rate should just permanently be zero.

00:28:32.140 | You know, I'm not an advocate of that.

00:28:33.380 | But you could set up a really simple algorithm that just even if even if the overnight rate

00:28:39.300 | was pegged at, you know, something close to like the rate of inflation, or you could set

00:28:44.060 | up a moderated like, you know, or modified Taylor rule where like, the, you know, the

00:28:49.380 | interest rate could change to some degree, but it stayed within like a band of like,

00:28:53.860 | like I theorize, I've theorized in the past that like, it can move from like two to like

00:28:58.140 | five within a band over time.

00:28:59.900 | And it would just be completely out of algorithm based, completely automated, data dependent.

00:29:05.940 | The Taylor rule is somewhat forward looking.

00:29:08.100 | So someone calling someone asked us this a couple weeks ago, like, could the Fed be more

00:29:12.820 | rules based?

00:29:13.820 | And my thinking was 95% of the time they could and the other 5% during a crisis is

00:29:18.420 | when you need them.

00:29:19.420 | But I think what we're learning now is that the Fed is way better at stepping in during

00:29:23.100 | a crisis than they are at pulling the punchbowl away like they they know what to do during

00:29:26.860 | a crisis.

00:29:27.860 | And I think that's actually easier, the easiest part of their job.

00:29:30.260 | And I think Powell did a great job in the pandemic.

00:29:32.980 | I think obviously, the other way they're showing that that that's much harder to know what

00:29:36.900 | to do and when.

00:29:37.900 | Totally, you know, and that's the thing, a lot of that tangential stuff, like, you know,

00:29:43.060 | having to manage things like a credit facility that goes to, like, you know, Bear Stearns

00:29:47.380 | or, you know, a big investment bank that's in dire need of something unusual.

00:29:52.300 | That's a very different scenario than the everyday management of something like interest

00:29:57.340 | rates, like interest rates for the most part, I think could be it could be very automated,

00:30:02.420 | systematic, something that people just were mostly hands off with.

00:30:06.740 | And of course, even that model will have its flaws, but at least it won't have the discretionary

00:30:12.900 | impact that we now kind of know almost always lags because people are just bad at predicting

00:30:18.660 | stuff.

00:30:19.660 | I mean, everybody, literally everybody is bad at predicting stuff.

00:30:21.980 | And so but you still need even if you had this like self-driving car version of Fed

00:30:27.980 | policy, you still need somebody behind the wheel.

00:30:30.620 | You need someone to pay attention.

00:30:31.620 | The car kind of starts to get wobbly.

00:30:34.220 | And so I think that's I mean, that's what I would do, frankly.

00:30:37.980 | I would you still need people manning the ship, but you don't need like you said, you

00:30:42.180 | don't need 20 people doing speeches every day, just yabbering about what's going on

00:30:48.540 | with the economy and talking things, you know, off of what looks like a cliff edge here.

00:30:53.900 | So this might be I was just going to say it might be a stupid question, but I've always

00:30:58.380 | wondered why do we have all these different locations of Feds?

00:31:01.900 | Like what's the.

00:31:04.260 | They're like often they're offering different opinions on stuff.

00:31:07.340 | It just seems kind of part of the banking system, right?

00:31:09.820 | Yeah, different spots for the banks in those areas kind of really like back when the Fed

00:31:14.020 | was formed and the as it kind of developed, I mean, the banking system wasn't very integrated.

00:31:19.900 | And so it wasn't very nationalized.

00:31:21.180 | And so you had all these Fed districts that were they were kind of managing specific locations

00:31:26.060 | across the country and which now looks kind of silly because it's like, well, it's just,

00:31:31.420 | you know, I send a wire transfer and it doesn't matter whether you're in San Francisco or

00:31:35.820 | New York, like it just goes through.

00:31:38.580 | So it's kind of a I mean, a lot of the a lot of the structure of the Fed, a lot of the

00:31:44.100 | a lot of the existing management of it is somewhat archaic, you know, and that's, I

00:31:51.060 | think, becoming more and more of a problem as as the monetary system evolves.

00:31:57.100 | So there was a story today that St. Louis Fed President Jim Bullard gave like a behind

00:32:01.220 | the scenes speech to Citigroup.

00:32:02.580 | People are kind of up in arms about that, that the Fed moves markets.

00:32:05.340 | I think after today, the Fed is not going to be coming on Portfolio Rescue.

00:32:08.980 | We're a little harsh.

00:32:11.460 | It is what it is.

00:32:12.460 | Cullen, where can people find your work?

00:32:13.460 | Yeah, I feel like you might be fired from the Fed, Ben.

00:32:15.060 | Yeah.

00:32:16.060 | It's I turned my resignation a while ago.

00:32:17.460 | Cullen, where can we send people to find your work?

00:32:20.540 | Pragmatic Capitalism is my blog.

00:32:22.220 | I run an investment management firm called Discipline Funds.

00:32:25.780 | But yeah, the blog, Twitter, Cullen Roach on Twitter.

00:32:29.780 | So if you want to hear more boring stuff about the Fed, you know, that's where you can find

00:32:34.060 | me.

00:32:35.060 | Thank you, Cullen.

00:32:36.060 | We appreciate it.

00:32:37.060 | Yeah.

00:32:38.060 | Thanks.

00:32:39.060 | Yep.

00:32:40.060 | Yep.

00:32:41.060 | You're listening to the podcast.

00:32:42.060 | Remember, leave us a review.

00:32:43.060 | Send us a question.

00:32:44.060 | Ask the compound to a gmail.com if you're watching on YouTube.

00:32:45.060 | Leave us a comment.

00:32:46.060 | Let us know what you think you would do with the Fed.

00:32:47.060 | And we will see you next time.

00:32:48.060 | See everyone.

00:32:48.060 | Transcribed by https://otter.ai

00:32:49.060 | Transcribed by https://otter.ai

00:33:10.140 | (upbeat music)

What Is the Fed Doing? Portfolio Rescue 49

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