Fearing Inflation?
Markets will be laser-focused this year on inflation and the actions required to bring it under control. The latest reading for the Consumer Price Index (CPI) rose 7.9% from a year ago, its highest level in over 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. Additionally, the war in Ukraine has inflated some commodity prices, especially for energy.
Shifting consumer preferences during the pandemic from services to goods, compounded by supply chain constraints, has generated considerable inflation. 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 below 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. Core CPI growth, which excludes the volatile—and Ukrainian invasion affected—food and energy components, is slightly tamer with 6.4% growth year-over-year.
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 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 pivoting 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, beginning this month.
The coming change of direction in interest rates is a major force behind the volatility in stock prices this year. 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 been implemented, 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 a slower pace of 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 the timing of 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 and continued economic growth.
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
