The Federal Reserve has been in the news because of recent changes to the Fed’s targets for short-term interest rates. Last month, the Fed raised its target by 0.75%, following up a March increase of 0.25%. This development is part of the Fed’s attempt to tamp down inflation, which hit an annual rate of more than 8%1 during May.
What happens next? The Fed has to consider its “dual mandate.” As the central bank of the U.S., it’s supposed to support full employment and tame inflation. Employment is close to full, with an unemployment rate of 3.6%.2 That’s good, except for its potential impact on inflation. In contrast, inflation is running at an annualized rate of about 8%—much higher than the U.S. has seen for many years and far above the Fed’s target rate of 2%.
Inflation results from a mismatch between supply and demand for goods and services. The Fed’s tools tackle inflation by taming demand—not supply. Higher interest rates make it more expensive for consumers and businesses to buy goods and services, depressing demand. Lower demand can ease inflation to a degree. For example, the housing market is cooling, with more price cuts, fewer mortgage applications, and fewer people shopping for houses.3 However, there’s a limit to what lower demand can achieve. For example, without a drop in energy demand comparable to the decline imposed by COVID-19 lockdowns in 2020, energy prices are unlikely to fall dramatically from recent levels.
Energy prices are high in part because of a structural shift that has cut the energy supply. The Russian invasion of Ukraine in February resulted in sanctions making some of Russia’s oil unavailable to the U.S., the European Union, and other aligned nations. Prior to the invasion, Russia had exported 5 million barrels of oil a day out of a total 9 million barrels of oil production per day. The U.S. and northwestern Europe lost their former access to that oil, with more Russian oil now heading to China and India. Moreover, the world is experiencing what General Secretary of the World Energy Council, Dr. Angela Wilkinson calls “energy transition growing pains.”12 Anticipating the shift from fossil fuels, energy companies cut their capital investments. As a result, even if we can obtain more oil, limited refining capacity and long-term storage create bottlenecks. Yet, it’s too early for alternative “green” energy sources to have much of an impact. Indeed, world population growth suggests that, in the long run, alternatives may do little more than help energy supply keep up with demand.
There’s a similar problem with the global food supply. Russia and Ukraine accounted for a significant percentage of global wheat, sunflower seed oil, and corn exports before the war.4 Although supporters of Ukraine would buy Ukrainian food, Russia has blockaded Ukraine’s ports.
Russia’s invasion of Ukraine has dramatically changed the world’s political, economic, and market environments. To better understand the crisis in Ukraine, I picked up a copy of Lawrence Freedman’s book, “Ukraine and the Art of Strategy.” Freedman emphasizes that the conflict’s origins precede President Vladimir Putin’s aggression. The current conflict has deeper roots in the “shocks to the system resulting from the end of the Cold War, the breakup of the Soviet Union, and the growing activism of NATO countries.”5 From the Russian perspective, Western countries broke post-Cold War agreements when they allowed former Soviet states like Hungary, Poland, and the Czech Republic to join NATO. This seemed to threaten Russian security. Russia saw “a progressive disinclination to take its security concerns into account combined with a patronizing attitude to Russia as a potential pole of attraction for other former Soviet republics,” says Freedman.6 As early as 2007, Putin referred to NATO expansion as “a serious provocation.”
This stance underlies Putin’s 2014 annexation of Crimea and his support of separatists in eastern Ukraine—moves that followed the 2014 Ukrainian revolution and leading to a new government Putin considers illegitimate. Putin’s actions were partly a land grab and partly an effort to create a buffer zone just beyond Russia’s borders. The election of Volodymyr Zelenskyy in 2019 further unsettled Putin. Immediately after Zelenskyy’s election, Putin offered Russian passports to Ukrainian separatists,7 and eventually ordered Russian troops into eastern Ukraine.
The prospects for a relatively speedy resolution to the Russia-Ukraine conflict appear dim. On the one hand, Russia is losing significant military manpower, equipment, and supplies. Ukraine says it has killed 12 Russian generals8 and 33,000 Russian soldiers,9 in addition to destroying 1,477 tanks and 3,588 armored vehicles.10 One might hope those losses would undermine Russians’ will to fight and encourage Putin to negotiate for peace. However, “Putin is not prepared for any negotiations,” says Mikhail Kasyanov, a former Russian prime minister under Putin. Kasyanov believes that Putin wants to avoid being viewed as a weak or defeated leader and as a result, the war will be decided on the battlefield.
Thus, we’re unlikely to find significant relief from high energy prices soon. High energy prices are felt in many ways. The movement of goods—and the production of some goods—becomes more expensive, affecting almost anything you can buy.
It looks as if inflation will be around for a while. It may take two years for inflation to abate to 2%, as Cleveland Federal Reserve Bank president, Loretta Mester said on June 19.11 Keeping that in mind, our portfolios are overweighted with companies in sectors that tend to perform better during high inflation. Their strength comes from an ability to raise prices or because demand remains steady regardless of what’s happening in the broader economy.
There are pockets of fixed income where I am looking to initiate or add to positions. Bond prices have suffered because of investors’ concerns about higher interest rates. Those lower prices make some bonds look like better buys.
As always, thank you for the trust you have placed in me and in 7Summit Advisors. We work hard to earn that trust each day.
7Summit Advisors is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance