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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).