Is the Fed Wrong on Inflation?

5/25/21: One of the latest debates circulating in the halls of the Federal Reserve is whether or not the recent consumer price spike we’re experiencing will be transitory. The current thinking among Powell & Company is this inflationary moment will be transitory and will not require a deviation from their current, ultra-stimulative monetary policy. Investors, who initially bought the Fed’s argument, aren’t so sure. The most recent inflation report raised some doubts.

Year-over-year inflation has been accelerating in recent months. US consumer prices popped 0.8 per cent in April, the highest monthly increase since 2009. The report showed sharp monthly increases in travel-related activities, like automobile rentals, airfare, and lodging, reflecting a gradual economic reopening. The 4.2 per cent annual inflation rate caught many economists by surprise.

The surprisingly strong pricing readings did not appear to shake the Fed’s view that April’s CPI report was but a temporary blip, and that inflation will ease back toward its long-term trend in the coming months. Fed governors argue that those areas of the economy exhibiting the strongest price gains, like food, fuel, and air travel, could easily retreat as supply picks up and meets elevated demand. Central bankers are more focused on “sticky” pricing components, like education, medical care, and rent, where price hikes are less likely to be reversed. Viewing CPI components through that lens supports the Fed’s point of view. In fact, the Fed’s “sticky” CPI advanced only 2.4 per cent over the last 12 months while headline CPI spiked 4.2 per cent. History has shown that headline CPI tends to vacillate around its stickier counterpart.

Markets are also reflecting doubts. Major equity markets plunged between 2 and 3 percent in response to last week’s inflation report and they’ve been off balance ever since. The 10-year Treasury yield spiked to 1.7 per cent, but has settled back to 1.6 per cent. Treasury trading is difficult to interpret, however, given the Fed’s heavy-handed influence in that market. Thanks to quantitative easing, an emergency stimulus measure, the Fed purchases roughly $100 billion Treasury notes every month to keep intermediate interest rates in check; such massive buying overshadows all other yield investors.

Perhaps investors are latching onto other indicators suggesting that today’s price increases could escalate? Sustained inflation has two key ingredients. The first is wages. Wage gains are sticky – wages are employers’ biggest expense and pay increases are virtually impossible to reverse. Paychecks are on the rise, according to the April jobs report. Wages in leisure & hospitality, a category that includes restaurants, increased 2.7 per cent between March and April due to widespread worker shortages.  Average hourly earnings for private-sector employees rose 21 cents last month to $30.17, however, McDonald’s said it would raise wages over the next several months by about 10 per cent for its more than 36,500 hourly employees at its company stores in the US. Chipotle said it would raise wages at its 2,800 restaurants to an average $15/hour by the end of the month. Retailers Walmart and Amazon are raising employee compensation also. Walmart will be increasing its average hourly wage to about $15 after hiking pay to $14/hour in early 2020. News of fatter paychecks has barely registered among sidelined workers and, unfortunately, there are no long lines of would-be employees completing job applications. Their reticence to rejoin the workforce appears to be influenced by a several factors, including US schools not offering in-person classes, forcing parents to stay home with their kids. Health concerns also weigh on the decision to engage with customers and colleagues face-to-face. Employer and business groups point to the $300/week federal unemployment supplement giving less incentive to look for work as well. There is currently about one job opening for every unemployed American, approaching a historical record.

The second key ingredient behind sustained price increases is Inflation expectations. If consumers and business customers believe prices will rise in the future, their buying behavior and their compensation demands will reflect that view today. A recent report by Bloomberg observed that companies, sensing rising prices and production bottlenecks, are stocking up on critical commodities, like copper, iron ore and steel, creating even more severe shortages. Buyers are also hoarding lumber, semiconductors, plastic and cardboard packaging, which has only exacerbated price acceleration. In the last 12 months, lumber prices have expanded four-fold and copper prices have doubled. A recent survey by the National Federation of Independent Business (NFIB), a small-business organization, found that 36 per cent of its members plan to raise prices in the coming months. Historically, the NFIB survey has been a useful leading indicator of inflation’s direction. Last week’s University of Michigan survey of inflation expectations over the next 12 months found American households are bracing for a 4.6 per cent inflation rate, its highest level in over a decade. Both the one-year measure and longer-term inflation expectations rose substantially. These can become self-fulfilling prophecies if, like business buyers, consumer inflation expectations for tomorrow influence buying behavior and labor demands today.

We believe that Federal Reserve policy makers are underestimating inflation risk. Perhaps they’re comforted by their institution’s track record for keeping a lid on inflation over the last 40 years. That’s impressive, but Powell & Company will eventually need to respond. Meanwhile, the combination of rising inflation paired with restrained overnight interest rates creates a new set of investment opportunities, and risks. “Real” rates (the difference between interest rates and inflation) have been falling and are currently situated in negative territory across the Treasury yield curve. At 1.6 per cent, the 10-year Treasury’s real rate is -0.88 per cent, according to the US Treasury website. That means anyone buying bonds at today’s yields are locking in a lower standard of living through maturity.  Overnight yields are even worse. Currently set at zero, the Federal Reserve is on record projecting the overnight rate will remain at zero through 2022. While negative real rates are troublesome for bondholders, equity investors and commodity holders benefit from a widening gap between inflation and interest rates. Once the Fed and the bond market wake up to inflation’s reality and quantitative easing is scaled back, interest rates will rise. St. Louis Fed President Jim Bullard told Bloomberg News that monetary policy makers are waiting for 75 per cent of US adults to have received the COVID-19 vaccine as their indication to taper their bond buying program. We expect that to take place later this summer. Scaling back their $120 billion monthly bond buying program will untether intermediate bond yields, pushing nominal and real rates higher. We estimate the 10-year Treasury yield should be 2.9 per cent, not 1.6 per cent. A slow correction in interest rates would present a headwind for equities.  Perhaps equity investors are beginning to price in that scenario. For now, we’re taking a cautious view on equities, given their extended valuation, and prefer to keep a little dry powder in gold.