As of last inflation report (April, 2022) in US the broad-based inflation is 8.3% whereas fed rate
is 1%. This means the real fed rate is -7.3% and the fed’s neutral rate for 2% target inflation rate
should be 6.3% instead of 1%. The dilemma for Fed is if it raises interest rate relatively more
aggressively then it will choke the economic growth and induce recession. On the other hand, if
it does not raise interest rates more aggressively then the risk is that inflation will further catch
roots and will be more entrenched influencing wage inflation etc. For the Fed it is like walking
on egg shells, a very tight rope walk. So, Fed will keep trying to find Goldilocks to keep
economic chugging along and raise interest rates relatively gradually while using dialed-up
rhetoric and jawboning by mentioning that it will raise interest rates to tame inflation. This will
be a protracted communication and process where economic growth will be relatively slower
due to Fed’s gradual interest rates raising and prolonged elevated inflationary environment,
called stagflation.
In order to protect financial assets against stagflationary economic environment it is advised to
allocate primarily in assets that do relatively well to pass on inflation to consumers via value
stocks and broad-based basket of commodities with inflation protection.