Update From The Desk of The Chief Investment Officer, Greg Slater CFA, CFP®, CIPM®
With inflation touching multi-decade highs this year, many investors are understandably concerned about what’s driving it, when it will get better and, most importantly, whether it will impact their financial plans. To help answer those questions, we are providing an update on the state of inflation and its drivers today. The executive summary provides a quick and condensed recap of the biggest issues, while the full report provides additional details and insight for those interested in digging deeper.
• Recent data shows headline inflation is at multi-decade highs. This is putting pressure on the Fed to act, by raising short term interest rates and/or ending its large-scale bond purchases.
• Instead of being driven by a booming economy at full employment, inflation today is coming from areas that are harder to address directly, like supply-chain bottlenecks and the ways consumers are spending their income (i.e. spending on goods vs. services). The labor market is a particular challenge and is exacerbating supply, and inflation, troubles.
• Raising interest rates may slow inflation in interest rate-sensitive sectors like cars, trucks and houses, but will also slow economic growth more broadly.
• Rate hikes take time to have an effect (a “policy lag”). If the forces driving inflation today start to recede on their own during this policy lag, the Fed risks slowing economic growth at the exact time inflation drivers are already receding.
• With rates already ultra-low, and little appetite for additional fiscal spending, policy makers have few tools at their disposal to fight a slowing economy. The Fed must weigh the balance between keeping inflation in check and sending the economy off the cliff.
• The Fed’s decision to taper (reducing, not ending, its bond purchases) reflects the policy tightrope it is walking today, by allowing it to respond to criticism about doing more to fight inflation, while also buying more time to wait and see what, if anything, changes over the next several months.
• The 5-yr outlook for inflation still remains low and manageable. Investors are best served sticking to their long-term portfolio strategies driven by their investment policy statement. Sound financial strategies provides for, and anticipates, challenges like this along the way.
CPI, 12-month Percent Change, Selected Categories, October 2021, not seasonally-adjusted
Source: U.S. Department of Labor Statistics
The Bureau of Labor Statistics reported a .9% monthly increase in CPI, and a 6.2% increase over the last 12 months ending in October 2021. Energy prices are +30% over the last 12 months, including +50% in gas prices, +59% in fuel oil prices, and +28% in natural gas prices. Used cars and trucks are +26% over the last 12 months. Food is +5.3%, shelter is +3.5%, and medical care is +1.7% during that time. The chart below shows the trend in recent months is clearly higher than most of the rest of the last decade.
CPI for All Urban Consumers, seasonally adjusted
Source: U.S. Department of Labor Statistics
It’s still possible to assert that some of the supply factors driving prices higher are transitory, but given how long it may take for those forces to recede, and in considering the pressure policy makers are now seeing to respond to those forces, it may make the assertion irrelevant. The biggest challenges for policy makers now are the lagged timing any policy change may have on price levels, and the fact that this current bout of inflation is not driven by a traditional output gap resulting from an over-heating economy.
Aggregate demand has remained very strong as households continue to be flush with cash. The composition of demand though, and not just the aggregate level, is what’s stressing supply chains. Households have been spending less on services, like dining out and travel and leisure, and more on goods like furniture and appliances (see consumption chart on top of following page). This degree of spending imbalance could have strained pre-pandemic supply chains; any supply bottlenecks today only exacerbate the problem.
Real Personal Consumption Expenditures
Change from February 2020 through September 2021
Source: U.S. Department of Commerce and Wells Fargo Securities 1
Supply bottlenecks, which have been covered thoroughly in the media, do exist and have contributed to inventory shortages. These are not all due to COVID-related issues; the world has dealt with extreme weather, draughts, shipping blockages and others. COVID-related issues like dock laborer shortages and factory shutdowns globally are only part of the story. The other major supply bottleneck here in the US is labor. Though there are almost 10 million job openings today, businesses are having difficulty filling these open positions for a slew of different reasons. This triggers a virtuous cycle contributing to labor imbalances by limiting production capacity which in turn further limits demand for labor. It also directly leads to inflation. An overly-simplified example is a restaurant owner unable to hire new workers. If the restaurant is only able to produce and sell 80% the number of meals as before, prices need to increase 25% just to break-even. Given the abundance of “Help Wanted” signs, it’s little surprise the cost of dining out increased 6% year-over-year in October.
Total Nonfarm Job Openings (000s)
Source: U.S. Bureau of Labor Statistics
The Federal Reserve’s usual response to inflation is to raise interest rates. This has the effect of making credit more expensive, reducing disposable income and discouraging business reinvestment including hiring workers. All of this serves to slow down economic growth, and when an economy is booming this is precisely what the Fed wants. Raising interest rates today will make borrowing more expensive and help to slow down demand for big-ticket, interest rate-sensitive items like cars, trucks and homes by raising the financing costs for these purchases. The higher prices mean people will buy less of them. Since these are some of the major culprits of inflation today, cooling off these markets would help lower headline inflation. Technically this would help achieve the Fed’s mandate to price control.
A possible better solution would be to eliminate the supply bottlenecks, achieved by increasing production and hiring more workers. Raising interest rates discourages both of these. It becomes more expensive to build new factories since financing costs go up. It also becomes more expensive to hire more labor since labor costs go up. As a result, higher interest rates may make these shortages less transitory/more permanent while also choking out healthy demand-fueled growth.
TIMING IS IMPOSSIBLE TO PREDICT, BUT CRITICAL TO CONSIDER
Any decision by the Fed to start tightening (or become less accommodative) will take time to have an impact on the economy. During that same time, some of the pain points listed above may start to dissipate. As an example, we’re seeing some positive developments in the labor market. In the October BLS employment report, nonfarm payroll growth was +531k. 1.2mm fewer people lost work due to the pandemic (3.8mm total down from 5mm in September) and 300k fewer people were prevented from looking for work due to the pandemic (down to 1.3mm from 1.6mm in September). New service-producing jobs outpaced new goods-producing jobs by almost 5:1. Further progress worldwide will start to lessen the impact the pandemic has had on supply chains. Real goods imports to the US have been above pre-covid levels since 4Q2020, and though 3Q2021 imports were relatively flat against 2Q2021, they’re still 9.7% above pre-covid levels. The busiest US ports continue to regularly operate well above historical averages (see the chart on the top of the following page).
Ports Are Busier Than Ever in 2021
Combined In-Bound and Out-Bound Traffic, In Twenty Equivalent Units (TEUs)
Source: Bloomberg LP and Wells Fargo Securities 1
Finally, the glut of cash many households built-up during the pandemic will get spent down, and additional fiscal stimulus looks very unlikely. New credit card issuances are back up to pre-pandemic levels, and the trend of borrowers paying down credit cards using cash saved/received during the pandemic appears to have reversed. Demand will normalize over time as pent-up demand for deferred, big-ticket purchases is expended. Personal consumption is already well off its peak year-over-year gains. Demand, in short, will peak, if it hasn’t already (see charts below).
Quarterly Percent Change in Credit Card Balances Thru October '21
Source: New York Fed Consumer Credit Panel/Equifax
New Credit Card Applications by Credit Score
Source: New York Fed SCE Credit Access Survey
Quarterly Change in Personal Consumption
Source: U.S. Bureau of Economic Analysis
The lagged impact of policy action risks slowing down an already-imbalanced labor market and aggregate demand at a time when these and other inflation drivers may already be receding. Historically, raising interest rates has been effective against a traditional positive output gap at times when the economy is booming. But the economy today is not booming. Third quarter GDP slowed to a paltry 2%. Though job openings are high, labor participation is well below pre-pandemic levels. Consumer confidence numbers have also been weakening. Inflation is reducing purchasing power and household disposable income, and the benefits of fiscal stimulus are now behind us. The chart below shows the fading impact on GDP from fiscal stimulus.
Fiscal Stimulus is Fading Fast; Policy is Likely to be Contractionary in 2022
Source: Hutchins Center at the Borookings Institution, TD Securities
FIGHTING A GREASE FIRE WITH WATER
Paul Volcker was appointed Fed Chairman in August of 1979, facing 7.5% unemployment and inflation that had just hit 11% that June. While inflation was a prime concern, he felt the public’s perception of the Fed’s ability to fight inflation was just as important, as any loss in credibility “will only make any subsequent effort more difficult.” The Fed began tightening conditions and led the economy into the worst recession since the Great Depression. The Fed is once again today facing increasing pressure to fight the flames of inflation. But the forces triggering inflation may require a more patient and nuanced approach, and the Fed is concerned raising rates now will be as effective as fighting a grease fire with water. The risk in doing so may jeopardize the tenuous economic cycle we’re in now, at precisely the time when fiscal and monetary policy makers have few tools at their disposal to fight a slowing economy. This is because interest rates are already at ultra-low levels, the public has a dwindling appetite for additional deficit spending, and a deeply-divided government can’t be trusted to respond quickly or aggressively. The Fed must then weigh the delicate balance between keeping inflation in check and sending the economy off a cliff.
THE FED'S TIGHTROPE WALK
On November 2, 2021, the Fed announced that it would begin to reduce, or “taper,” the bond purchase program it announced as an economic stimulus in 2020. As of the time of this publication, the Fed has further indicated it will likely accelerate its taper and conclude the program by March or April of 2022, three months earlier than expected. The market wasn’t expecting the announcement, made by Chairman Powell before a Senate panel, but it underscores the tightrope the Fed is walking. By “tapering the taper,” the Fed is responding to criticism about doing more to fight inflation, without committing to rate hikes now. And, since the Fed has made clear it won’t hike rates before completing the taper, it gives the Fed the option to raise rates three months sooner, if conditions warrant doing so. While the decision gives the Fed earlier access to rates as a policy tool, it also buys them time: time to review data from a busy holiday and flu season before committing to new guidance, and time to see what, if anything, changes around the world regarding inflation, demand and supply constraints.
MANAGING PORTFOLIOS AGAINST THE BACKDROP OF HIGH INFLATION
Of course, this means the path forward, and particularly the next several quarters, is still highly uncertain. As we’ve maintained through our recent communications, investors are best served by sticking to a long-term, disciplined approach. While fixed income yields remain low, we continue to support owning fixed income in portfolios as indicated in an Investment Policy Statement (IPS). Our fixed income portfolios incorporate strategies, with clients for whom it’s appropriate, that may mitigate some of the impact of inflation. Equities, too, have historically been excellent inflation hedges, and continue to look attractive today as earnings remain strong and companies are passing higher costs onto customers. Even in the case of the ’81 recession discussed earlier, inflation had fallen to 5% by the fall of ‘82. Today the bond market is telling us a similar story as 5-yr TIPS breakeven rates hover around 2.5% - 3.0% despite the shadow of inflation. Keeping cash on hand for 6-12 months of spending needs and maintaining a disciplined investment portfolio will help navigate this storm. Sound financial planning provides for and even anticipates these sorts of bumps in the road. If you have any questions about your plan, please reach out to us to setup a time to talk.
Ryan Darmofal, CFA, FRM
Gregory Slater, CFA, CFP®, CIPM®
1 – Source: Wells Fargo Securities, “U.S. Monetary Policy: The Risks are Two-Tailed,” Link to full report here.
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