Rake Encounter

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TL/DR –

The 2008 Global Financial Crisis marked a significant shift in the financial and psychological approach towards capital allocation, risk management, and accountability. In the current environment, the rise in inflation is attributed to over 13 years of low or negative real interest rates, multiple rounds of quantitative easing, and “helicopter money” to address the COVID-19 pandemic. However, there is a question of whether peak inflation has been reached and if the Federal Reserve has found a way to curb spending without significantly impacting employment.


The Financial Impact of the 2008 Global Financial Crisis

2008’s Global Financial Crisis (GFC) triggered a significant financial and psychological shift. It represented a substantial debt transfer from corporate and private balance sheets to the US Government’s balance sheet. The event emphasized that if businesses are seen as systematically important, risk mitigation strategies are perceived as minor in terms of accountability.

Current Financial Climate and Inflation

Fast forward to today, and we’re in an era of artificially low or negative real interest rates, quantitative easing, and stimuli to combat the COVID pandemic. Consequently, we’re now seeing a surge in inflation, raising questions about whether the Fed has figured out how to control spending without significantly impacting employment rates.

Looking at the past, this macro-environment mirrors the inflationary period of the 1970s, which had three peaks before calming down. As history often repeats itself, it’s plausible that inflation could come in waves. However, several marked differences limit the Fed’s options now, particularly the current federal budget deficit, which is around 130% of GDP, compared to only 40% in the 1970s.

Fed’s Strategies to Combat Inflation

Should further waves of inflation hit, it seems the Fed’s choices are either to allow inflation to exceed the 2% target, thereby reducing interest payments via dollar devaluation, or to implement stricter measures on the economy. Only time will reveal the outcome. As pointed out by Jeffrey Gundlach at Grant’s 40th Anniversary, the Fed’s strategies have led to a situation where we don’t measure core economic elements like food, energy, and shelter, which might present a potential problem.

The Fiscal and Monetary Theory Now vs Pre-1970s

The current fiscal and monetary theory starkly contrasts with the pre-1970s era. Then, the government maintained a balanced budget and allowed poorly allocated business investments to liquidate. Today, companies and consumers have sizeable cash reserves, and the Magnificent 7, who have near monopolies on their markets, make up 30% of the S&P 500. Additionally, their combined market caps are larger than the GDPs of Japan, Germany, and India combined.

However, the real question is what the Fed’s strategy would be if we face additional waves of inflation? Would we allow inflation to run well above the 2% target to reduce interest payments via dollar devaluation, or come down hard on the economy? More to be revealed in the future.

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