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Understanding the current economic cycle and what the FED is doing

Hello! Today I want to talk about the current economic cycle we're in. It's very much, in my view at least, an economic cycle still well within the shockwave Covid caused, the largest result of said shock being high inflation. We do have several other factors contributing to inflation currently, namely the war that started between Russia and Ukraine in the 1st quarter of the year which sent several commodities and goods soaring in prices more, but I believe we're still in the economic event of trying to stabilize what was a rapid, big shakedown caused by Covid.

We are ending 2022 as an year where there's barely any stocks ending above their January 1st levels. Many investors out there are hurting, many have folded, some have outperformed indices and have had gains this year. For those that are hurting and may lack some macro knowledge, I hope today's post will help contextualize the current economic cycle, and in addition to that, help you better your decision making in what's currently a downtrend in the economy and stocks. The Covid shock, in hindsight, was supposed to be a big demand shock (negative), hence why equities flash crashed, with people flocking from stocks anticipating a big drop in company revenues, in example. However, it rapidly turned into a negative supply shock. This shock was supposed to be temporary and quick enough that central banks needed not to worry about inflation, but it turned out the shock was long enough to move central banks, namely the US FED, to change their policies. This cycle should still be temporary, albeit a long one.

So, today I'll look into the cycle of a temporary supply shock, taking a page from macroeconomy theory, what are the appropriate measures to deal with it, what has currently been done, where exactly are we in the cycle, and when will the US FED pivot their economic policy stance.

Picture 1: Supply shocks reduced to the basics

To help really understand the cycle we're at, we need to go deeper than just the events that are described in the picture above, but you can get a quick summary of the whole deal above. To aid us, we'll use some graphs to help us really know what's going on. We'll use some measures and terms in the graphs below, namely:

- AS: Autonomous Supply

- AD: Autonomous Demand

- π: Inflation

- MP: Monetary Policy

- Y: Production level

- r: central interest rates - ASLP/Yp: Long-term Production Potential (to simplify it)

With these definitions and terms in place, let's start with some basics:

Picture 1: Supply and Demand - Point of Equilibrium + Inflation level and Production

In this graph, we can see there's always an equilibrium between supply (AS) and demand (AD) in a perfect economy, by microeconomy theory. The point where both intersect is called point of equilibrium, with production at level Y*, and inflation rate at π*. The point of equilibrium is, in theory, where everyone would like to be for an economy to be balanced in terms of growth, wages, unemployment, and so on.

Picture 3: Supply Shock and Inflation

When there's a supply shock like we had with the Covid breakout, there's not enough production/supply to keep up with demand, and as such, production drops below its potential (Yp to Y2*), and because of pent up demand and a rush from companies to try and produce more goods/services, costs of goods rises, and so do selling prices to consumers - the Autonomous Supply curve shifts up (AS1 to AS2), and inflation rises (π1 to π2).

Now that we have some basics explained, let's try to move on to the full cycle of a supply shock, shown in the complex graphs below, as well as applying these to the current economics in the USA and what the Federal Reserve is currently doing. On the left, we have a graph correlating Monetary Policy (MP1) with inflation (π). On the right, we have a graph correlating Production (Y), inflation (π), as well as Autonomous Supply and Demand curves (AD1 & AS1) drawn on top. Applying real life to this post, we have:

πT is target inflation rate of 2% for the FED

r* is target central interest rate

Yp is production potential (or to make it easier, where we were before Covid appeared and the shock occurred).

1. As mentioned on Picture 3 and looking at the right graph, when there's a supply shock, the Autonomous Supply curve shifts up (AS1 to AS2), and inflation rises above the FED intended target of 2% (π2 > πT). Production falls to Y2, below its potential of Yp. To combat inflation, the FED maintains its monetary policy and raises the interest rate from r* to r2, in the MP1 curve. We actually have a 1 to 1 example of this in real life, which is the first raise the FED did this year in 2022. The rate hike was 0.25 points, which is usually the standard move in the FED's monetary policy.

2. With inflation running way too hot, and target inflation still well above the FED target level, simply raising rates along the MP1 curve isn't enough. Comparing to this year's events, with rampant inflation after the first 0.25 hike in March, because of the Russia/Ukraine war, the FED decided it had to shift in Monetary Policy. As such, they began having much more restrictive policies and i.e. started raising rates by a whooping 0.75 points. Back to our theory, this change in policy means shifting of the monetary policy curve up, from MP1 to MP2, and rates from r2 to r3, which means for the same level of inflation, the actual real interest rates will be higher (use πT on the left graph to observe this). This shift and tightening means personal consumption, investments from companies and broadly speaking, demand falls. With this, the Autonomous Demand goes down, so the AD1 curve shifts to AD2, which moves the economy even further away from its potential (Y3 < Y2 < Yp). However, at the new equilibrium of the AD and AS, inflation is now at the FED target rate of 2%.

3. Inflation is now back to target level, but the economy has been destroyed to way below its potential (Y3 < Yp), so the FED now needs to spruce the economy, by maintaining its policy, but lowering the interest rates along the still much more restrictive MP2 curve. The FED brings interest rates down to r4. This affects the supply side positively, which shifts the Autonomous Supply from AS2 to AS1, and production levels at Y2. While we're back to Y2 production levels, now the inflation is below target rate of 2% (π3 < πT), , which is not ideal, either, while in 1. it was above inflation target. At this stage, the economy is back closer to its potential (Yp), but still a way off of it.

4. With the cycle nearly over and needing a final push in opening up the economy, the FED now enters in an easing period or loosening their fiscal and monetary policy. As such, the monetary policy curve shifts back from MP2 to MP1, and rates go down once more. Not only the rates themselves, but the complete easing of the FED in many more areas result in more demand from families and people, which moves the Autonomous Demand curve back from AD2 to AD1 which, as you can see the the graph on the right, brings us back to the full potential of production and the economy (Yp), which is where we were before the supply shock occurred, with inflation right on the FED target (πT).

And, finally, the cycle is over. We can now have our "normal" economy back.

But baka, why is this so confusing?

It's confusing because I don't want you to have to spend 3 weeks studying macroeconomics to understand what's going on so I kinda have to try and summarize it the best way I can. I know it's not easy to grasp it at first, but go back and read it carefully just two more times while playing attention to the 4 events and the arrows guiding you in the graphs along the way. Everything will make sense in your head after a bit.

What does this mean for us investors, then?

Well, in all truthfullness what this means, is that now you know what a negative supply shock cycle is as per Picture 1, but more than that, we know what each cycle represents, what happens to us (we are the demand side), the companies you invest in (the supply side), and what the FED does in each component of the cycle.

So now, you know where the f*** we are in this mess of a cycle. Doesn't matter whether you're reading this today after another 0.25 hike in yesterday's FOMC meeting, or in one year's time. Now, because you know how everything reacts together and intertwines, you can read inflation data, GDP data, rate hikes and stock market movements, and know at least in theory and broadly speaking, where we're going next. It's important to try and "know" where we go next, maybe even more than what happened in the past. We should always remember economies are hard to control because they are indeed hard to control, and unpredictable. As such, this blog post serves so you can better yourself with your investments, not as a crystal ball that will tell exactly what's gonna happen next. Maybe another war breaks out tomorrow. Maybe the big one currently going ends. No one really knows, and macroeconomy theory isn't right all the time.

Hindsight really is 2020

However, looking in hindsight, the cycle has been steady going so far, for the most part. We had the supply shock in 2020 with Covid, and inflation rose. A new war broke out and it made it worse. We had the FED raising interest rates and shifting MP to be way more restrictive. Inflation is not rising anymore, but only just last month came below expectations and shown a mild decline, so it's still a long way off from reaching target levels of 2%. Some layoffs have happened, but not many. Unemployment is still way too low. The economy has yet to be destroyed. After that is accomplished, FED will need to lower interest rates, and then finally pivot, to get us back just to before it all began. At least now you "know" when the pivot might actually happen. So... What do I personally think? I think we're still in phase 2. of the cycle, We have a long way to go still before the economy is destroyed enough that the FED will start pivoting with points 3. and 4. I truly hope I have made this an easy read for you, and I hope you have learned something useful for your investments today.

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