inflation: Aswath Damodaran questions US Fed’s response to inflation, sees pain ahead

Valuation guru Aswath Damodaran in his latest blog said the inflation genie is out of the bottle, and if history is any guide, getting it back in is going to take time and create “significant pain”.

Damodaran, who had in 2021 argued that the Fed should take inflation seriously, and respond quickly, even if there existed the possibility that it was transient, said the Fed and administration chose a different path and are now finding themselves between a rock (more inflation) and a hard place (a recession).

The valuation guru said the path Fed chose was one that can be described “as whistling past the graveyard, not just ignoring the danger with happy talk, but also actively taking decisions that only exacerbated the danger,” he said in his blog Musing on Markets.

Inflation & markets
Damodaran said the nature of markets is that they are never quite settled, as investors recalibrate expectations constantly and reset prices.

In most time periods, he said, those recalibrations and resets tend to be small and in both directions, resulting in the ups and downs that pass for normal volatility.

“Clearly, we are not in one of those time periods, as markets approach bipolar territory, with big moves up and down,” he said.

The good news, the valuation guru said, is that the culprit behind the volatility is easy to identify, and it is inflation. The bad news, however, is that inflation remains the most unpredictable of all macroeconomic factors to factor into stock prices and value, he said.

Recalling 1970s
Damodaran said investors who are old enough to remember the 1970s point to it as a decade of high inflation, but that is only with the benefit of hindsight. At the start of that decade, he noted, investors had no reason to believe that they were heading into a decade of higher inflation, and initial signs of price increases were attributed to temporary factors (with OPEC being a convenient target).

Inflation in early 1970s in fact lagged actual inflation through much of the decade, and “the damage done to financial asset returns that decade came as much from actual inflation being higher than expected inflation, period after period, as from higher inflation.”

Because we have been spoiled by a decade of low and stable inflation, the inflation numbers in 2021 and 2022 came as such a surprise to economists, he said.

Who wakes up Fed?
Damodaran said if one were to graph out when the Fed woke up from its inflation-denial and when treasury rates started rising, it seems clear that it was the treasury market that is causing the Fed to act, rather than the other way around.

As treasury rates have risen, markets also seem to have been more wary about risk, and how it is being priced.

Damodaran said as the inflation bogeyman returns, the worries of what may need to happen to the economy to bring inflation back under control have also mounted.

He cited a note published in mid-April by Larry Summers and Alex Domash that went as far as to put the likelihood of a recession at 100 per cent, based upon a joint indicator that says a combination of inflation of over 5 per cent and unemployment of over 4 per cent has always led to a recession within 12 to 24 months.

“I remain a skeptic about historic rules of thumb (downward sloping yield curve, for example) to make predictive statements about future economic growth, I think that we can state categorically that there is a greater chance of an economic slowdown now than just a few weeks ago,” he said.

(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)

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