Just recently, I received word that my daughter had been called down to the principal’s office at her middle school.

Now, as someone who has also been called to the principal’s office before, my stomach churned thinking about what she did for this to happen.

But then to my relief, I discovered she was being recognized as a student of the quarter!

Over the weekend, it sounds like Federal Reserve Chairman Jerome Powell also received a call to his principal’s office … this one belonging to President Biden.

But I’m fairly sure that Powell isn’t being recognized as central banker of the quarter. Ahead of midterm elections, Biden is reaching for anything that can be done to tame inflation.

And unfortunately for us all, there is only one thing Powell can do.

Set Your Phaser to Stun

The Fed is a frequent scapegoat for the nation’s inflation woes. That stems from a concern for most investors that persistently low interest rates and repeated rounds of quantitative easing for the better part of 13 years have finally come back to bite us.

But as Ted has argued frequently, the Fed’s easy money policies did more to boost financial assets as opposed to stoking inflationary imbalances in the real economy.

In reality, today’s issues have more to do with the response to the pandemic, snarled supply chains and a growing commodity crisis. Regardless of the root cause, President Biden is squarely putting the responsibility on the Fed to get inflation under control.

So, what can the Fed do? Well, officials surely can’t fix supply chains, pump more oil or harvest more wheat. But what the Fed can do is reduce demand for all that stuff.

And as they hike rates while reducing their $9 trillion balance sheet, you’ll be able to feel and see this process play out in two distinct phases.

Ted told you about the first phase this week, which is through something called the wealth effect. That’s a powerful psychological factor that causes people to spend less as their perceived wealth decreases — which is already underway as stocks plunge and interest rates jump.

And if the stun from the wealth effect isn’t enough to get inflation under control, then get ready for the next phase … because it won’t be pretty.

Set Your Phaser To…

Phase two for the Fed is intentionally pushing the economy into recession.

That would have even greater consequences for aggregate demand than the wealth effect alone. I’m talking about a spike in unemployment in addition to plunging stock prices. We only have the latter at the moment.

And to monitor the severity of the next phase, I’ll be closely following new claims for unemployment benefits. That’s because it’s a high-frequency data point that’s reported every week, which makes it an almost real-time snapshot of the labor market. Here’s how claims rose ahead of the recessions in 2001 and in 2008:

unemployment claims in 2001 and 2008

A recession would also worsen the wealth effect mentioned earlier.

That’s because of a chart from Ned Davis Research that shows what tends to happen to the S&P 500 following an 18% decline like we just reached. Avoid recession, and the stock market rallies back toward the highs (the black line). If a recession is to come, then we’ve historically seen the blue line … a small rally before another sell-off.

S&P 500 following 18% declines: Recession vs no recession

The Fed is bent on stamping out inflation, but what we don’t know is at what cost.

That’s why I’ll be following early warning recession signals and the implications it has for your portfolio.

Best regards,

Clint Lee
Research Analyst, The Bauman Letter