J Scott Explains Inflation, Interest Rates & the Economy

The Fed's Reaction to Inflation [00:04:30]

The Federal Reserve has shifted its stance, moving from a period of lower interest rates to actively raising them. This change is a reaction to concerning trends in inflation and economic growth that emerged around February-March, coinciding with the start of the war in Ukraine. The Fed's primary concern is price stability, one of its two mandates, which is threatened by rising inflation.

"The Fed is getting a little concerned that their first mandate or one of their two mandates, which is price stability, basically ensuring that prices don't go up too fast, is a threat to this country."

Impact of Rising Interest Rates [00:05:36]

The Fed's decision to raise interest rates has direct consequences for individuals and businesses. Increased borrowing costs mean higher expenses for car loans, business loans, and mortgages on homes or investment properties. This tightening of credit is a deliberate attempt by the Fed to manage inflation.

"And so again, us as investors, as business owners, because ultimately that impacts our borrowing costs. When interest rates go up, it costs more to buy a car. It costs more to get a business loan. It costs more to get a mortgage on a house or an investment property."

The Fed's Mandates: Price Stability and Employment [00:03:10]

The Federal Reserve was established over a century ago with two primary objectives: price stability and maximum employment. Price stability refers to controlling inflation, ensuring prices do not rise or fall too rapidly. Maximum employment focuses on maintaining smooth and upward economic growth. These two mandates guide the Fed's actions and are considered crucial for the nation's economic health.

"And so I like to think that the reason that the Fed exists is because those are the two things that are most important when it comes to the economy, when it comes to Americans, when it comes to basically us as a nation economically continuing to grow."

The Fed as a Reactionary Force [00:04:58]

Jay Scott views the Federal Reserve as a reactionary body, akin to the rear-wheel steering on a long fire engine, guiding the economy to prevent it from going off track. The economy is seen as the driving force, with the Fed adjusting its course based on economic conditions rather than dictating them.

"The analogy that I've used in the past is if you imagine those really long fire engines where there's a guy in front driving the fire engine, but the really long ones have the guy in the back and he's kind of controlling the back wheels to make sure that the engine doesn't go off the road from the back. And that's the Fed."

Energy Prices and Inflation [00:06:17]

Rising energy prices, particularly due to the war in Ukraine, are a significant contributor to current inflation. While the Fed cannot directly control oil prices, it acknowledges that high energy costs threaten both price stability and economic growth. The Fed's strategy involves increasing interest rates to curb overall consumer spending, which in turn is expected to reduce demand for energy.

"Higher energy costs impact both of those things. Higher energy costs are a risk to both of those mandates by the Fed."

Demand Destruction Strategy [00:07:24]

The Fed's approach to combating inflation, especially when driven by energy costs, is to create "demand destruction." By raising interest rates, the Fed aims to slow down consumer spending. This reduced spending is anticipated to decrease the demand for energy, leading to lower prices. It's viewed as the most viable, albeit not optimal, solution available to the Fed.

"They're hoping to slow down spending by American consumers and less spending means less need for energy. Less need for energy means less demand. Less demand means lower prices."

Discretionary vs. Necessities [00:08:50]

While essential goods like groceries and utilities remain necessary regardless of price, higher energy costs indirectly affect their prices due to transportation expenses. However, the Fed's rate hikes are expected to impact discretionary spending more significantly. Consumers may cut back on non-essential purchases like travel or luxury goods, and potentially save more due to higher interest rates on savings accounts.

"But then there are plenty of other things that are more discretionary. People aren't necessarily going to fly as much when jet fuel prices are super high and airline costs are high."

Historical Economic Policy and Inflation [00:10:30]

There's a debate about whether the Fed mishandled inflation in 2021. While some criticize past decisions, others argue the Fed managed the situation reasonably well after initially missing the mark, particularly with rate hikes. The nomination of Kevin Warsh by Trump, who was seen as more hawkish, surprised some, as he appeared to align with the Fed's mandate of reacting to economic conditions.

"I think that the Fed did a pretty good job. It's easy to look in retrospect and say, hey, they should have done this. They should have done that."

Transitory Inflation and Soft Landing [00:11:50]

Two key questions from the recent past were whether inflation would be "transitory" and if a "soft landing" would be achieved. While inflation lasted longer than a few months, lasting perhaps a year and a half to two years, it eventually came down. The economy also experienced significant GDP growth, low unemployment, and positive real wage growth after the Fed's rate hikes, suggesting a soft landing was achieved.

"Basically, we saw tremendous consistent GDP growth after 2022 when after the Fed had hiked rates. We saw unemployment stay below 4%."

Types of Inflation: Demand-Pull vs. Cost-Push [00:15:40]

Inflation can be categorized into demand-pull (driven by high consumer spending and money supply) and cost-push (driven by rising production costs, like energy and supply chain issues). The post-COVID surge in consumer spending fueled demand-pull inflation, while current inflation is more characterized by supply-side constraints.

"What we're seeing today is more of a supply side inflation, specifically a supply constraint inflation."

Supply-Side Inflation Factors [00:16:45]

Supply-side inflation is currently influenced by global conflicts (Ukraine, Iran), tariffs, and immigration policies. Tariffs, in particular, are seen as inflationary by increasing the cost of imported goods. Changes in immigration policy can affect labor supply, leading to higher wages and increased costs for goods and services.

"Tariffs, number one, have, in my opinion, been a horrible idea. We've used tariffs for 150 years in this country, but mostly we use what are called targeted tariffs."

Monetary Policy and Inflation [00:18:40]

Overprinting money and increasing the money supply are identified as significant drivers of inflation, as they devalue the currency. While the immediate impact of money printing on short-term inflation can vary, the long-term effect is an increase in prices. Both past and present administrations' fiscal policies, including stimulus packages and deficits, are scrutinized for their inflationary contributions.

"Basically, you're devaluing the dollar. And so all the money that was printed in 2020, all the money that was printed between 2021 and 2025 during Biden, and now all the money that's being printed in the second term under Trump is going to cause tremendous inflation."

Tariffs and Economic Policy [00:19:35]

Broadly applied tariffs, as implemented by the Trump administration, are criticized for being inflationary and potentially harming trade relations. While targeted tariffs might protect specific domestic industries, general tariffs on goods like coffee or bananas, which cannot be produced domestically, primarily lead to higher consumer prices.

"But then when you say, hey, we should tariff coffee for some reason, coffee we can't make in the US, bananas, we don't get a lot of bananas in the US. These are things that putting a tariff on them."

Immigration Policy and Inflation [00:21:30]

Immigration policy has a dual effect on inflation. Reduced immigration can decrease the labor supply, particularly in sectors like agriculture and construction, leading to higher labor costs and thus higher prices for goods and services (supply-side). Conversely, fewer immigrants also mean less demand for housing and other commodities, potentially lowering prices (demand-side).

"And immigration hits inflation negatively on the supply side. Basically, it drives up labor costs when you have fewer workers, especially when you have fewer workers in industries where a lot of Americans historically don't want to be working."

Housing Costs and CPI Calculation [00:24:00]

Shelter inflation, a significant component of the Consumer Price Index (CPI), is calculated based on existing leases, creating a lag effect. While new leases might be signed at higher rates, the impact on the overall CPI metric is delayed. Factors like real wage growth and landlord qualification requirements (e.g., rent not exceeding one-third of income) can limit rent increases, potentially moderating housing cost inflation.

"Housing costs in real terms are not rising fast and in some cases are falling across the country."

Real Wage Growth vs. Public Perception [00:27:00]

Data indicates that real wages have grown significantly since 2014, contradicting the common narrative of stagnant wages. While historical data showed flat real wages for decades, recent years have seen consistent growth. This discrepancy highlights a potential disconnect between official economic data and public perception, possibly influenced by the memory of past economic conditions.

"And people just, they don't believe it. They don't, they don't like, it doesn't register because the narrative, you know, in 2014, 2015, 2016 was real wages have been flat for 20 years."

Historical Inflation vs. Fed Target [00:30:30]

While the Fed targets 2% inflation, historical average inflation over the last 120 years has been around 3.1%. Inflation rates around 3% are not historically uncommon. The Fed's 2% target was set when inflation was very low, aiming to stimulate the economy. If the target were reset today, it might be higher, reflecting current economic conditions.

"If you look over the last 120 years, inflation has run on average about 3.1%."

Why Inflation Feels High [00:32:00]

Inflation feels particularly high due to the significant spike in 2022, which elevated prices across the board. Energy prices are a major catalyst, impacting transportation, electricity, and the cost of virtually all goods due to shipping expenses. Unlike specific products that can be substituted, energy is a fundamental cost that affects the entire economy.

"But when the price of fuel goes up, it impacts every part of the economy. It has a direct impact on our driving costs, just transportation because gas is more expensive."

Oil Market Dynamics and Future Outlook [00:34:30]

The oil market is complex, influenced by geopolitical events like sanctions on Iran and potential changes in production from countries like Venezuela. While current supply constraints may keep prices high, future developments could lead to lower oil prices. The cost of extracting oil, particularly from unconventional sources, plays a crucial role in market dynamics.

"There's a real reason to believe, I think, that the current situation in Iran could continue indefinitely and still, and that will spike prices for one to three more years."

The Fed's Dilemma and Market Rates [00:38:00]

The Fed faces a challenge in controlling market-driven interest rates, such as the 10-year Treasury yield, which significantly impacts mortgage rates. Despite the Fed's actions, these rates have reached multi-year highs, driven by investor concerns about inflation, geopolitical risks, and government deficits. Investors are demanding higher returns due to perceived economic instability.

"The 10-year treasury rate, and I don't know when this is going to be released, but the day that this is being recorded, the 10-year treasury rate, which is the thing that impacts mortgage rates the most, hit a high since July of 2007."

Money Supply and Investor Expectations [00:41:00]

While the M2 money supply has seen fluctuations, concerns about excessive money printing and government deficits persist. Investors' expectations and confidence in the government's ability to manage the economy play a crucial role in driving interest rates higher. Fear of long-term inflation and economic instability leads investors to demand greater compensation for lending money.

"And so there's a lot of structural issues in the economy, too much money printing, not enough demand for certain types of bonds, concerns over inflation, concerns over geopolitical risks, concerns over government that are driving rates up that, again, that may be out of the control of the Fed and the Treasury at this point."

Long-Term Economic Outlook and Investor Strategy [00:47:00]

Energy supply shocks are typically short-term, but their long-term impacts, such as structural changes in inflation and interest rates, are uncertain. While oil prices might decrease, the increased money supply and Fed policies could keep interest rates elevated. Investors are advised to focus on controlling expenses and maintaining long-term investment strategies, such as diversified index fund investing, rather than trying to time the market based on short-term economic news.

"It's just a question of whether all the things that it caused in the meantime are going to stay with us for another two years, five years, or 20 years. And that's the hard question to answer."

Controlling Expenses in a High-Interest Environment [00:50:00]

In response to rising interest rates and inflation, a key strategy for investors is to control expenses. The Fed's goal is to reduce demand, and individuals can align with this by rigorously reviewing their budgets and cutting unnecessary spending. This proactive approach to personal finance is emphasized as a critical best practice, especially in the current economic climate.

"And I think that with rising interest rates, what does the Fed want you to do? They want you to stop spending. They want to drive demand down."

Jay Scott's Newsletter and Analysis [00:53:00]

Jay Scott offers a newsletter available through his website, jscott.com, where he provides regular updates on economic matters. His analysis aims to be objective, though he acknowledges that discussing topics like the Iran war, oil prices, and tariffs inherently involves political considerations. He strives to avoid partisan viewpoints, aiming instead to make sense of complex economic and political issues.

"If you go to jscott.com, the letter J-S-C-O-T-T.com, that will link you out to everything I do, including the newsletter that I send out a couple times a week."

The Challenge of Objective Economic Analysis [00:54:30]

Analyzing economic policy objectively is challenging due to deeply ingrained political beliefs. It's difficult for individuals to separate their opinions of political figures from the impact of their policies. The podcast hosts and Jay Scott acknowledge this challenge, aiming to provide a balanced perspective that considers the real-world economic outcomes of political decisions.

"The challenge is how do you actually think about these items in an intelligible way? And I think if you believe that the vast majority of policies from the Biden administration are good for the economy and the vast majority of the Trump administration are bad or vice versa, you've got a really big problem."