The 2% Titration Experiment
One of our portfolio companies specialized in the remediation of chemical waste. It often received shipping manifests for liquids purporting to be a harmless mix of chemicals.
Once that barrel had been accepted for processing the contents of the barrel became our portco’s environmental responsibility. The only defense against accepting unwanted toxic waste was lab testing every barrel.
Often that test used a chemistry process called titration where known concentrations of chemical reagents were slowly mixed to discover if the mystery contents were properly identified.For example, if the manifest claimed a stable liquid fertilizer which was really a quite volatile sulfuric acid, the titration process would reveal the truth and pave the way for either safe in-house remediation or returning the barrel to the customer.
The Fed’s Titration Experiment
There is great relief among investors now that The Fed has started its own titration process of raising rates and stopping asset purchases to combat inflation with a goal of returning to a neutral rate of 2% . Unlike a typical titration where the ratios of a known titrant like hydrochloric asset can identify an unknown substance, the Fed is conducting a completely experimental titration where it does not know how anything will react to its chemistry until after the experiment has been run.
I had not fully grasped the enormity of the chemistry experiment until last week when Lisa Beilfuss in her last article for Barrons on November 7 entitled, “Why Higher Interest Rates Won’t Solve the Problem” suggests that raising interest rates is just the first chemical titrant in the quest for low concentrations of inflation. She thinks it may also take a massive, $4.0 Trillion unwinding of the Fed’s balance sheet as well as a more willing population of workers to return to a safe 2% solution. She acknowledges this analysis comes from Societe General as follows:
“Markets are on two counts oblivious to the significance of QT, says Solomon Tadesse, head of quantitative equities strategies North America at Société Générale. His model says that if the Fed is to bring inflation back to its 2% target, then some $3.9 trillion in balance-sheet shrinkage must accompany a policy rate of at least 4.5%. That amount of QT, he says, is equivalent to an additional 4.5 percentage points of tightening.”
She also points to a study by The Brookings Institute that predicts that inflation won’t be cowed until there is a more willing labor force as well:
“Consider a September study by the Brookings Institution, which found that labor-market tightness explains three-quarters of the rise in the monthly consumer price index, excluding food and energy prices and outliers. Inflation is becoming more entrenched, largely because of the very tight labor market and the fast wage growth it has triggered, says Gad Levanon, chief economist at the Burning Glass Institute.”
It is too bad Lisa is leaving Barron’s. She always writes the story all the other financial journalists won’t acknowledge. We all have been conditioned to hope interest rates alone will neutralize toxic levels of inflation. Whereas William McChesney Martin is credited with saying it was the Fed’s responsibility to “remove the punch bowl” after the party got out of hand, this time the Fed is titrating a strange brew labeled “Caution: Highly Inflationary” and it has to define the right mix to neutralize the danger.
Early lab tests show four successive interest rates increases have lowered the acid content but, in the process, have destabilized the debt market, the stock market and the housing market. More of the same may be risking an asset implosion so the titration experiment must proceed slowly and reactively, especially if it has to shrink liquidity and stem wage inflation to get back to a neutral 2% inflation solution.
A larger point of focus is how this debt unleveraging will unfold. Here is a snapshot from the most recent edition of “Grants Interest Rate Observer”:
“Investors have now discovered that everything is correlated to the Fed, and they are also discovering that most, if not all, of last decade’s investment acumen was really nothing other than market beta and in some cases, nothing other than levered market beta.”
Interpreting this for financial mortals means many investment gurus simply got hooked on the Fed’s low interest/ high liquidity meth lab formula and made untested, highly leveraged bets on what the speculators in all markets were cooking up without regard to risk.
According to Lisa Beilfuus, now that the inflationary chemistry is proving to be toxic and complex to analyze, the Fed’s chemistry lab has to experiment with a careful titration of higher rates, lower liquidity and workforce expansion without blowing up the domestic test lab and the world’s economy. I hope someone at The Fed has an advanced degree in financial chemistry?
The above commentary is for informational purposes only. Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.
