The Feds’ strategy to mitigate the effects of inflation is demand destruction

It’s no secret that the global economy is experiencing turbulence. The transition to a post-COVID world is further complicated by world events. According to the International Monetary Fund’s World Economic Outlook:

“Several shocks have hit a world economy already weakened by the pandemic: higher-than-expected inflation worldwide—especially in the United States and major European economies—triggering tighter financial conditions; a worse-than-anticipated slowdown in China, reflecting COVID-19 outbreaks and lockdowns; and further negative spillovers from the war in Ukraine.”

In this globalized society, how different countries manage inflation directly affects global citizens. The US economy is known for its stability and is one of the most influential economies in the world. Those who have foreign investments, assets, and residences are carefully monitoring inflation rates to effectively manage their holdings. According to the US Bureau of Economic Analysis (BEA),The foreign direct investment in the United States position increased $506.1 billion to $4.98 trillion at the end of 2021 from $4.47 trillion at the end of 2020.” This substantial increase in foreign investment in the US shows that international investors favor the US market in the face of the macroeconomic shocks identified by the World Economic Outlook.

Throughout 2022, managing inflation has been the number one priority for the Federal Reserve. The FED’s record pace of monetary policy action has led many in the financial community to describe their strategy as something called demand destruction.  Jerome Powell, chair of the Federal Reserve, recently spoke at the annual Jackson Hole Economic Symposium. With inflation hitting a 40-year high in the United States, his goal was to assure the American people that the Fed would not let inflation continue to rise. One of the largest challenges associated with this goal is reducing inflation without sending the economy into a tailspin. According to Powell:

“There will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.” 

Powell’s strategy is centered on the idea of demand destruction.  The concept of increasing the cost of borrowing money, in order to encourage the decrease in demand. How does this actually work? Increasing the cost of borrowing money affects both Individuals as well as businesses. For example when purchasing property there are two options. The first is to purchase outright, the second is to finance the purchase by borrowing money, in other words getting a mortgage. The majority of individuals and businesses choose option two. The Fed’s decision to raise interest rates does not affect the initial list price of the property; what it does affect is the cost of borrowing said money. As the cost of borrowing increases the affordability of the same piece of property decreases. This inturn decreases overall demand. This process operates similarly across industries. 

Inflation is affecting essential purchases the most. Purchases like expanding  a business, buying  a home, and traveling are often deemed non essential. As the cost of borrowing increases, these types of purchases are deprioritized. Industries such as oil, metals, and agriculture can’t be deprioritized because they directly affect day to day life. As such the demand for goods and services connected to these industries continue to outpace supply, causing persistent inflation.     

Kristina Hooper, the chief global market strategist at Invesco, explained how the global pandemic triggered rising inflation. “We turned off [the] economy, and then we turned it back on,” she explained. When the economy started to recover, many countries were waylaid by labor sourcing and supply chain issues, which, she noted, “contributed to scarcity of supply just as demand increased.”

According to Hooper, coming out of the pandemic we have a supply- demand imbalance. Because of shocks identified earlier by  World Economic Outlook globally we do not have the capacity to increase supply, therefore the Fed is aiming to destroy the demand to restore equilibrium in the markets. 

Beyond the unprecedented conditions presented by the post-COVID reopening, the Federal Reserve has been faced with challenges from fiscal policy.  Fiscal policy, or the economic actions of Congress and the White House, has been focussed on large spending bills such as the Infrastructure Bill and the Inflation Reduction Act.  The names of these bills may be confusing, as they include many different areas of policy, some of which are likely to cause an increase in inflationary pressures. These bills authorize massive government spending which increases aggregate demand; running counter to the Federal Reserve’s demand destruction strategy.  Larry Fink, Founder and Chairman of BlackRock and a frequent supporter of the administration, described this conflicting monetary and fiscal policy as an “irreconcilable disconnect” while encouraging the current administration to work in harmony with the independent Federal Reserve.

Demand destruction is a delicate dance. Too much demand destruction can cool the economy and cause a recession; too little, and the FED’s actions won’t make a dent in the inflation rate. As the Federal Reserve continues to use monetary policy to fight inflation, while the current administration bolsters demand through fiscal policy, investors are making an effort to understand how they can best manage their investment holdings worldwide.