Inflation and The Federal Reserve – Taking Action

“If we see inflation persisting at high levels longer than expected, if we have to raise interest rates more over time, we will.” – Federal Reserve Chair Jerome Powell.

Powell’s quote above is quite a turnaround from his comments earlier last year in which he stated inflation will prove to be “transitory” as he and the rest of the Fed seemed focused on spurring economic growth to aid the job market in its COVID-related recovery. Now the cat is out of the bag, and much of the inflation pressure isn’t as transitory as the Fed portrayed. Consumer prices have risen by 7% over the last year¹ (See the Year-Over-Year change in the Consumer Price Index chart below.)

Source: NoSpin Forecast 

In his news conference on Jan. 26, 2022, Powell said the Fed would start raising rates in early March, as their bond purchase program winds down. He didn’t say anything about potential bond sales but left that issue open. As Powell said, the Fed will plan on raising Fed Funds rates by 0.25% every other month going forward. He didn’t say how long that plan would be in place. I suspect we will see the Fed raise rates four times this year.

Let’s take this opportunity to focus on the inflation question, and to take another look at our growth forecast compared to the overall “consensus.”   

Economic Growth to Cool

As many know, my forecast for GDP growth this year is 3.0%, a “normal” rate of growth compared to the last two years of radical recession and growth expansion. Per a recent article and economist’s survey results in The Wall Street Journal, consensus expectations for growth this year at 3.6% has changed.  Now, economic growth is expected at 3.3% for 2022, which is pretty much in line with our thinking.    

The drivers behind the lowering in growth expectations are the wider-than-expected spreading of the recent COVID strain, continuing supply channel dislocations and higher inflation, all which should slow consumption and investment plans.

Additionally, the same survey shows a significant uptick in economists’ belief that inflation pressures will remain more intense throughout much of this year, as compared to previous poll results. The latest all-item CPI (December) came in at 7%;² the highest annual rate of inflation in decades. As reported in the October survey of last year, economists were expecting inflation of 2.4% by the end of 2022. They now expect inflation of 3.1% by the end of this year. We have been calling for inflation rates to fall back to 3.0% by the end of 2022. 

As can be seen from the data above, economists’ view in the October survey were calling for nominal GDP growth of 7%. That expectation has now contracted to 6.4%. Our expectation of 6% nominal GDP growth remains. I believe that inflation pressures will remain rather robust over the next few months, as highlighted in my recent commentaries.

My overall macro-economic theme has been (and remains) a return to normal. Consensus is now within earshot of our outlook. 

Source: NoSpin Forecast

Inflation to Remain a Clear and Present Problem in Near Future

I am becoming concerned about the “stickiness” that seems to be developing regarding the future path of inflation pressure. Consider the following: 

• Rents – which is how the housing cost segment of inflation is calculated, is starting to ramp to the upside. OER (Owner’s Equivalent Rent) is the largest single component of the CPI calculation. If this factor starts to reflect even a portion of the 16.9% increase in the median home sales price from 2020 to 2021,³ we should expect reported inflation to remain elevated. 
• Labor costs – another “sticky” driver of higher inflation, don’t seem to be letting up. The labor market is showing signs of maturity, which normally takes quite some time to come to fruition during a business cycle. Most businesses report continued upward pressure on wage rates. 
• Inflation expectations – as noted above, both economists and consumers believe inflation pressure will continue to be rather robust. Irrespective of this being accurate, risks are accelerating for a self-fulfilling prophecy[SF3] .

• Shipping bottlenecks – by most “learned” estimates, shipping bottlenecks, which have led to significantly higher transportation costs and outright shortages, will continue in many cases into 2023. For example, Strategas created its SLIM Index (Strategas Leading Indicator/Manufacturing Index. See ISM Mfg Supplier Deliveries chart.), which shows both deliveries and the diffusion index of deliveries. The index is structured to show slowness in delivery time. The higher the index, the slower the delivery of goods. As can be seen in the chart, improvements in delivery times have occurred over the last few months, but delivery delays are still very high in relation to historical norm. This is a good indicator of rising delivery costs and potential inflationary impact.     
• Intermediate producer prices – according to work done by our friend, Dr. Robert Dieli, No Spin Forecast, upward of 60% of the components of this index have been rising for three consecutive months, driving PPI finished goods inflation higher. In other words, there appears to be little in sight for the CPI gains to slow by producer prices starting to level.

Source: Strategas

So, we have those five pieces of information, all leading toward the conclusion that, while inflation may not ramp upward from here, we will probably not see a strong improvement in reported CPI levels for several months going forward. I’m looking for inflation to stay elevated until the spring months at the least. Following that, I see the combination of Fed activity, the lack of a surge in government spending and increased consumer tension regarding inflation leading to a slowing in overall economic growth, and with it, a lessening in inflationary intensity. 

What Will the Fed Do?

Now of course, the Fed has access to all the above information and more. With Powell’s announcement on Jan. 26, 2022, it has become apparent that their main worry is now inflation, whereas their main concern over the last couple of years has been “full employment.” As the jobs market has healed, the Fed is now shifting its attention to building inflation pressures. There are some who believe the Fed is “behind the curve” or, is late to the inflation-fighting party. I tend to agree with this sentiment.

With that background, based on historical precedent, what should investors think? When the Fed starts to change base monetary policy, as is the case now, what has happened in the past? Interest rates rise, money supply growth slows, and the dollar has tended to weaken.

The “U.S. Dollar Performance 6 Months Before & After First Fed Tightening” chart shows how the foreign exchange (FX) rate of the dollar has changed six months before and six months following the last eight Fed initial monetary tightenings. As can be seen, the dollar has tended to weaken following the Fed’s first tightening move. Normally when the dollar weakens, gold prices tend to rally, and foreign stocks have tended to outperform U.S. equities. Going back over the last 21 years shows that, as the dollar has declined, gold has increased in value 86% of the time.⁴  

Source: Strategas  

History as a Guide for Interest Rate Expectations

Of course, interest rates rise during tightening cycles, that is what monetary tightening is all about – the Fed attempting to “cool” economic activity to keep a lid on inflationary pressures. Ned Davis Research data shows that in all tightening cycles in the past from 1963 to present (10 cycles), the 10-year Treasury yield has risen by 133 basis points, on average, during the entire tightening cycle. Today, the 10-year Treasury is yielding 1.8%. 

Given that historical precedent, we believe it is rational to expect to see the 10-year yield rise to 3.2% this cycle. As far as duration is concerned, the average tightening cycle has lasted 490 days, or 1.3 years.⁵  

As the Fed takes action and interest rates rise, the yield curve has flattened during typical tightening cycles, as short-term rates rise more than long-term rates. In several cases, this has led to an inverted yield curve, which, in the past, has been a strong precursor to an economic recession. History shows that, over the last 10 Fed rate increase cycles, bond market yield inversion has eventually occurred on eight occasions. There is an old saying on Wall Street – that the Fed “engineers” recessions. This is historical data backing that old saw. 

Catalysts Present to Soften Inflation Later in 2022

From an “inside baseball” view, I suspect inflation will remain elevated for a short period going forward, due to the “stickiness” of measured items, which should be gaining traction. Rents and wage rate growth are both accelerating. Housing (rents is the main measure here in the index) is just starting to reflect the 18%+ gain in housing values last year, and wage settlements of 5%+ gains are becoming common.⁶ Both issues should drive reported inflation higher for the next few months. This should bolster consumer attitudes and convince people that inflation is truly a problem.

But I still believe we will see a retreat of inflation later in the year.  

• GDP growth this year (growth excluding inflation) should slow to the 3% range, as reported earlier, compared to the hyper-growth rate of about 7% in 2021, which overwhelmed the global supply chain, driving prices higher. This catalyst for higher prices is receding.
• Growth in government spending and the Fed’s financing of this spending appears to be slowing. Monthly money supply growth (M2) rates peaked in April of 2020 at 6.4%^.7 The latest monthly data from the St. Louis Fed shows M2 grew by 1.2%. While still an elevated growth rate compared to a 60-year average growth rate of 0.6%,⁷ money growth is starting to slow.
• A main near-term catalyst toward lower inflation centers on the “non-sticky” side of the inflation equation, being represented primarily by non-energy and non-food commodities.  This category represents the second heaviest weight of the CPI calculation. What are “non-energy and food commodities”? It is kind of a “grab bag” of various items, which, in total, increased in price by 10.7% over the last year^.8 This area has been the biggest driver of “core” inflation recently. This segment is considered “non-sticky” inflationary items that tend to rise and fall quickly, whose prices don’t become ingrained, and tend not to drive inflation expectations. I don’t expect these items will rise by 10% in value this year.
• A softening in reported inflationary pressure should benefit by the fact that the biggest numbers of monthly inflation change in 2021 occurred during the first six months of last year.  The highest inflation monthly rates will be rolling off the year-over-year computations during the first half of 2022.   

All in, I expect to see inflation move back toward a 3% level by the end of 2022.

Longer-Term Vision

Longer term, labor productivity growth rates will alter the ability of businesses to absorb rising labor and raw material costs, irradicating the need to raise prices aggressively. The bad news – worker productivity declined by 0.6% for the year ending the third quarter of last year.⁸ The good news – capital spending (non-residential fixed investment) grew by 9% in the most recent data last year. This is a strong level of capital spending, as capital spending has risen by a mere 2.6% on average per year over the last five years.⁹ The seeds for higher productivity growth are being planted, which should alter inflation’s long-term trajectory lower.

However, as I have said in the past, I think the days of deflation/disinflation being the main challenge and focus of the world’s central banks is behind us. The days of positive inflation and positive interest rates are ahead of us.

I will close today with the following quote. 

“I do not think it an exaggeration to say history is largely a history of inflation, usually inflations engineered by government for the gain of governments.” – Friedrich August von Hayek

Sources:

¹Dr. Robert Dieli, NoSpin Forecast

²Bureau of Labor Statistics

³National Association of Realtors

⁴Ned Davis Research

⁵St. Louis Federal Reserve

⁶S&P CoreLogic Case-Shiller Home Price Indicies

⁷St. Louis Federal Reserve

⁸Bureau of Labor Statistics

⁹U.S. Census Bureau

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