What Price Will We Pay To Restore Price Stability?

03.23.2022: Over the last decade, central banks and equity investors had it all: low interest rates, robust growth and no inflation. It was an ideal time for risk taking. The S&P 500 expanded by 362 per cent while interest rates spent mostly hovered between one and two per cent. Then the pandemic threw cold water on the party. But did it, really? Perhaps it wasn’t the pandemic, but rather policymakers’ reaction to the pandemic, that fed Goldilocks to the bears.

It was definitely the latter. The confluence of demand spurred by government support payments and supply shortages prompted by lockdowns pressured prices at a rate not seen in over 40 years. Restoring the delicate balance, by raising interest rates to quell inflation without damaging the economy, is Federal Reserve Chairman Powell’s mission. His aspirational task won’t be easy, as the Fed prepares to raise rates six more times this year and five more times next year, according to official projections. The overnight rate is anticipated to reach 2.8 per cent in 2023, slightly higher than the neutral rate, which is estimated to be 2.4 per cent.

The last time the Fed tightened was in 2018. Since then, the Federal Open Market Committee slashed rates to near zero, resulting in two years of nearly free money. The good news: from today’s vantage point, the probability of recession over the next 12 months is low, according to the Fed’s indicators. The bad news: history tells us that central bank tightening often results in economic recession. Beginning in the 1970s, 13 of the last 16 rate-hike cycles implemented by central banks in the US, UK and the Eurozone ended in recession, according to The Wall Street Journal.

Meanwhile, inflation is elevated and will likely remain high. Thankfully, long-run inflation expectations are muted, suggesting that households and businesses have not changed their behavior and are not hoarding goods or demanding higher prices and wages. In fact, the opposite appears to be true. According to the University of Michigan Consumer Sentiment Surveys, consumers are holding off purchases of automobiles and other big-ticket items in the hope that supply shortages, and prices, will ease. Longer-term inflation expectations have increased but, unlike the 1970s, they remain well below next year’s expected inflation rate. In fact, Americans anticipate the five-year inflation rate, five years from now, will be 1.1 per cent. Like many Americans, the Fed believes pricing pressure will ease on its own. The Fed’s preferred inflation gauge, the PCE deflator, is running at 6 per cent now and is expected to fall toward 4 per cent by year end, according to Fed estimates. That figure assumes supply-chain pressures will ease.

Graph 1, Market Update, 03.23.2022

The Fed hopes it will be able to perform the crucial balancing act of snuffing out inflation while not triggering a recession. Chairman Powell remains optimistic that the economy, which the Fed estimates will expand by 2.8 per cent this year, is strong enough to withstand higher interest rates and tighter financial conditions. So far, equity investors are taking him at his word. Bond investors, however, believe he’s quixotic. US large caps rose 8.1 per cent last week, their best weekly showing since 2020. Bonds, meanwhile, fell as rates rose. The yield differential between 2-year and 10-year notes flattened to 0.22 per cent, perilously close to inversion. Each of the last six yield curve inversions accurately predicted a recession. Moreover, the yield premiums lenders require to extend credit to lower-quality borrowers have widened, signaling caution.

Graph 2, Market Update, 03.23.2022

Meanwhile, the unemployment rate is extremely low, at 3.8 per cent, and the labor market is extremely tight. In fact, there are currently more than 11 million job openings for 6.7 million job seekers, an astonishing 1.7 job openings for every unemployed American – a relationship we have never seen before. Yet, at 7.9 per cent, the CPI is at a level not seen since the 1980s. The 10-year Treasury yield is a double-edged sword. Higher rates tend to correspond to strong growth, but they also compress valuation multiples. We estimate that, all other things being equal, a quarter-point rise in the 10-year Treasury yield equates to a five per cent decline in equity markets.

Graph 3, Market Update, 03.23.22

Russia’s invasion of Ukraine adds to the complexity by amplifying inflation and weighing on growth. The conflict is boosting prices for energy, food and other commodities, like nickel. Europe’s economy is particularly vulnerable: the OECD estimates the war in Ukraine will trim more than one percentage point from global growth this year, while pushing inflation 2.5 percentage points higher across the globe.  Historically, energy peaks tended to weigh on growth. High energy prices, while devastating for Europe, offer a mixed picture in the US owing to the development of our nation’s oil industry. Energy consumption represents less than 10 per cent of US GDP, just one-third of its share in 1980 and substantially lower than European energy spending relative to GDP.

Graph 4, Market Update, 03.23.22

Chairman Powell recently told the US Senate Committee on Banking, Housing and Urban Affairs that he is prepared to do whatever it takes to bring inflation down, following in the footsteps of his predecessor, and hero, Paul Volcker. Under Volcker in 1981, the Fed raised overnight rates to 20 per cent, triggering a recession and double-digit unemployment. The S&P 500 fell about 15 per cent between August and September that year before ending the year off about 6 per cent.

The Fed will eventually extinguish today’s inflation flare up, although this might come at the expense of the business cycle. Zero inflation is likely a thing of the past: the disinflation trend of the last 40 years has reversed, as most of the incremental benefits of globalization have been wrung out. The new environment will likely prompt the Fed to loosen its inflation target above two per cent. Real assets, like commodities, real estate and other inflation hedges, will become a more relevant in portfolio construction.

“. . . no one expects that bringing about a soft landing will be straightforward in the current context – very little is straightforward in the current context.” – Jerome Powell

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