Fearing Inflation?
We entered 2021 with promising new vaccines, oodles of fiscal and monetary stimulus and almost no inflation. We exited with a highly contagious Covid-variant, tighter monetary policy, 7% inflation and rising tensions with Russia and China. Despite these new headwinds, the economy continues its robust growth with few signs of significant easing anytime soon.
All eyes in 2022 will be focused on inflation and the efforts needed to bring it under control. The Consumer Price Index (CPI) rose 7% during 2021, its highest level in 40 years. Strong consumer demand combined with capacity constraints and global supply chain problems have led to shortages of parts and products that have pushed costs higher across a broad array of goods. Lockdowns in China and elsewhere embracing zero-tolerance Covid policies, as well as worker shortages for factories, ports, flights, trucking companies and warehouses in the U.S. and overseas have exacerbated the problems for the timely production and distribution of enough goods to meet demand.
Shifting consumer preferences during the pandemic from services to goods, compounded by supply chain constraints, has generated much of the excess inflation. Four categories of goods that combined make up only 14% of the overall CPI basket accounted for roughly two-thirds of the increase: new cars, used cars & trucks, apparel and household furnishings. An unprecedented surge in the money supply, exceeding 40% over the past two years due to generous fiscal and monetary stimulus programs, helped fuel this demand. While savings rates have normalized, over $2 trillion in accumulated savings stockpiled during the pandemic.
Price increases are becoming more widespread. Now that the unemployment rate has fallen to 4%, wages are gaining momentum, especially at the lower end of the pay scale. Rents are rising, as are energy prices and the cost of food.
Unfortunately, inflation is likely to stay elevated over the next few months as easy comparisons from a year ago are used as the baseline, then should start to improve later this year when comparisons become more challenging. Waning impact from Omicron, supply chain improvements and energy prices likely leveling off will also moderate inflationary pressure in the quarters to come. Therefore, economists expect CPI growth to fall to around 3% by the end of this year.
Controlling inflation is primarily the job of the Federal Reserve. Following nearly two years of propping up the pandemic-stricken economy by keeping interest rates near zero, the Fed is transitioning to inflation-fighting mode. While officials expect price gains to slow considerably, they are closely watching how quickly that happens as they contemplate the pace of rate increases. Investors currently anticipate numerous rate increases this year, likely beginning in March.
The coming change of direction in interest rates is the primary driver behind the volatility in stock prices recently. While the Fed hasn’t actually increased rates yet, investors are behaving as if it has already occurred and a number of hikes have already taken place, a process referred to as “discounting” future events. The Fed set this in motion when it signaled in December that it would more quickly reduce open market bond purchases put in place during the pandemic to support the economy. That opened the door for earlier rate hikes. While good for maintaining economic stability and lengthening the timeframe of this economic cycle, investors were initially anticipating slower increases beginning somewhat later this year.
In addition to raising rates, investors are also discounting additional monetary tightening as the Fed begins to shrink its balance sheet. Those ongoing bond purchases resulted in trillions of dollars in assets at the Fed, much of which will eventually return to the private sector. The Fed has considerable flexibility for how and when this reduction process will take place, but investors again are making assumptions that it will happen more rapidly than previously anticipated.
Fed actions on raising rates and reducing bond holdings are very fluid and not on a predetermined path. The Fed has made it clear that it will be guided by economic conditions and that its ultimate goal of a return to 2% inflation is flexible. Fed officials also very well understand the complex interrelationships between the capital markets and the economy, one generally drives the other and vice versa. They seek to walk a fine line between controlling inflation, growing the economy and creating a welcoming environment for investors.
Investors are anticipating considerable monetary tightening in the year ahead, which stocks are currently discounting as bond yields climb. Even if numerous rate increases do occur, that doesn’t necessarily mean that stocks are a poor investment choice at this time. History shows us that it is quite the contrary. We have had seven periods of rising bond yields since the mid-1990s, ranging in length from 6 to 37 months. Stocks increased in value, often significantly, throughout the duration of each of these periods of rising yields.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
