A century ago, New Yorker George C. Parker "sold" a lot of large local items to a gullible public – the Metropolitan Museum of Art, Grant's Tomb and, of course, the Brooklyn Bridge! What to say of the majority of investing public that believed Federal Reserve Chairman Jerome Powell's repeated assertions about inflation being "transitory" before he abruptly pulled the call following renomination to his position by President Joe Biden in October?

Powell did not withdraw the safety net entirely or immediately. As recently as March 16 – with the Russia - Ukraine war already in its third week – Powell maintained that the central bank could bring inflation down from 40-year high levels to the Fed's 2% target without a significant loss of jobs. FOMC participants actually expected the unemployment rate to decline to 3.5% by the end of 2022 despite tightening, and staying at that level thereafter, he indicated. The public bought that story as well. For the next Powell shift, we had to wait for only a couple of hours after the US Senate confirmed him by an overwhelming 80 - 19 vote on May 12. Following his confirmation, the Chairman declared that a soft landing could be "quite challenging".

Powell's forecasts have become more dire since. He told the Senate Banking Committee last Wednesday that achieving 2% inflation with a strong labor market would be very challenging. "We've never said it was going to be easy or straightforward," he said in answer to a question. He also admitted that higher interest rates could put the economy in recession. Had the Chairman forgotten that this contradicted what he had said last October and as recently as March, ignoring some of our repeated warnings about the threat to the economy from high and sustained inflation?

On inflation, in contrast to his sanguine approach through most of last year, Powell told Senate and House committees, "we are highly attentive to inflation risks and determined to take the measures necessary to restore price stability." Unfortunately, after his swift and repeated changes in position on the economy and its prospects, the Chairman may not have much credibility left. And there is no telling what steps he will actually take in coming weeks and months, and how they could affect markets.

How then, can we reconcile Powell's travails with the rally in equity and bond markets this past week? The S&P 500 index was up 6.4% during the week, and the yield on 10-year Treasurys closed the week at 3.14%, down sharply from the June 14 close of 3.48%. A decline in consumers' inflation expectations over the next five to ten years from an earlier estimate of 3.3% to 3.1% helped financial assets. The view that inflation may have peaked due to demand destruction resulting from a recession also led to a more benign view regarding how much the central bank will have to tighten.

There is a key factor that could end last week's optimism. As I have long maintained, and repeated (here and here), we appear to be entering a stagflationary environment, not just a recession. As we learned from 1973 - 1975, and again from 1979 - 1981, the key difference in impact is that both equities and fixed income instruments turn out to be losers in stagflation – recession and a hit to corporate earnings cause equities to drop, while high inflation rates erode value in bonds.

With Powell forced to admit in recent testimonies that the Fed can do little to mitigate inflationary pressures stemming from higher energy prices or scarcity of food items, expect inflation to persist at high levels even during a recession. Demand destruction that could slow inflation in a recession did not work in the 1970s – there were no substitutes for crude oil or gasoline.

Today's high inflation comes to a large extent from energy and grocery items for which demand is quite inelastic. Fed measures will do little to bring those prices to manageable levels. Another essential item in the consumer basket that is likely to stay elevated is rent. The central bank was a contributor to surging home prices with its purchase of agency mortgage backed securities until March as part of its Quantitive Easing program. Now, with a lag, potential home buyers, frustrated by high prices and surging mortgage rates are, instead, boosting rents.

President Biden admitted in an interview with Associated Press on June 16 that American consumers are "really, really down," stressed by covid and the high price of gasoline. He emphasized, however, that a recession is "not inevitable."

Sadly, like other economic predictions by his administration, this wish is unlikely to come true. A recession combined with high inflation rates is the likely scenario over the next 18 months.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California