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    Home»Kuo’s Smart Take»Smart Thought Of The Week: Trade-off
    Kuo’s Smart Take

    Smart Thought Of The Week: Trade-off

    The fittest will survive.
    David KuoBy David KuoMay 15, 2022Updated:May 16, 20223 Mins Read
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    Central bankers have suddenly remembered why they get up and go to work every day. They are not – as some seem to think – there to find solutions to the problems that their own governments have been unable to solve.

    But their remit is a simple one – it is to control inflation. And quite frankly, many have been asleep at the wheel. They can say what they like about asset-price inflation being volatile, and that it is a function of market forces that is beyond their control.

    But house-price inflation is still inflation. Share-price inflation is still inflation. Bond price inflation is still inflation. And don’t get me started on inflated cryptocurrencies and over-inflated SPACs. They can all be symptoms of too much money chasing a limited supply of goods and services. That, by the way, is the definition of inflation.

    Thankfully, albeit belatedly, central bankers have woken up. It still took them a while to wipe the sleep from their eyes, though. For ages they were denying the existence of inflation. Instead, they continued to maintain that rising prices were transitory. Now they are terrified that inflation could become embedded…. if it isn’t already.

    For central bankers there is no easy way out. The only useful tool they have is interest rates. And they will use it forcefully until inflation is brought firmly under control. Anything that stands in their way will be collateral damage, even if it means indebted companies going to the wall, massive levels of unemployment, and property foreclosures.

    Higher levels of unemployment could even be their end game. Economist A.W. Phillips argued that there is a difficult trade-off between inflation and unemployment. He said that in order to drive down inflation, it might be necessary to drive up unemployment to reduce aggregate demand.

    It has already started. The UK government has said that one in five or 91,000 civil servants are set to lose their jobs in order to balance the books. In the US, mortgage rates have already climbed to their highest since 2009. In the weeks and months to come, the fallout from rising interest rates could grow.

    Worryingly, the rising interest-rate environment could persist for longer than many expect. Currently, inflation in the US is running at over 8%, whilst the Fed Fund rate is a paltry 1%. It would take 14 rate hikes of 50 basis points each time for the Fed Fund rate to catch up with the inflation rate.

    It will be painful. But here’s the thing, not every company will go bankrupt. Not every worker will be made redundant. Not every homeowner will face repossession. The fittest will survive. And our job as investors is to stay invested in the best because as Warren Buffett quipped: “Only when the tide goes out do we discover whose been swimming naked”.

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