Increasing attention to whether inflation is a problem for the U.S. economy and financial markets isn’t resolved easily by looking at the most recent economic and financial market data. COVID-19-related economy and market adjustments continue to confound market observers and policy makers.
Inflation likely will surprise on the upside, Treasury Secretary Janet Yellen reminds us, and the New York Federal Reserve Bank reports that consumer inflation expectations are rising. How do we interpret June’s 5.4% 12-month consumer price index increase alongside a decline in the 10-year U.S. Treasury rate to 1.18% July 19 mid-morning?
Recent inflation data point to May and June spikes being transitory: base effects, pent-up consumer spending exacerbating supply-demand mismatch and broken supply chains.
What do the data say? The three largest components of the CPI basket: shelter (32.7%), food at home (7.6%) and medical services (7.1%) were up 2.6%, 0.9% and 1% for the 12 months ending June 2021. These components would need to change fundamentally for inflationary pressures to become systemic and problematic. The biggest CPI changes were in used cars and trucks (up 45.2%) and energy (24.5%) which represent 3.1% and 7.1% of the CPI basket, respectively.
Massive fiscal and monetary stimulus have flooded fixed-income markets, so it is hard to know exactly what bond yields are telling us. Are they reflecting a belief that inflation is under the Fed’s control and that recent CPI spikes are largely transitory? Or, are they reflecting a continuing gross domestic product output gap and global, deflationary pressures from demographics and technology-driving productivity growth?
The U.S. economy is growing robustly, businesses are experiencing reopening successes, and S&P corporate earnings per share continue to surprise on the upside. First and second quarter corporate earnings are showing year-over-year gains of 50% and 60%, driving down price/earnings ratios as prices growing into accelerating earnings growth.
With the Federal Open Market Committee having had the “talk” about talking about tapering its $120 billion per month bond-buying program at its June 2021 meeting, it likely heralds a coming reduction in the rate of money growth, some speculating it will begin as early as the end of 2021. Likewise, various fiscal payments also are tapering, and U.S. Treasury new issuance needs will be declining.
So financial markets seem to be looking through recent base-adjustment and reflation CPI drivers which are largely transitory and relying on more hawkish Fed assurances about vigilance. There is also renewed concern about COVID-19 and the apparent strength of the Delta variant, which appears to be more resistant to prior infection immunities in largely non-vaccinated communities. While local shutdowns aren’t likely in these communities, the surge in Delta variant infections may exacerbate labor shortages and delay consumer spending — both are contributors to inflation pressures being transitory.
It is easy to be frightened by our recollections of damaging inflation during the 1970s and 1980s. Although dangerous to think “it is different this time,” the 2020s are a very different environment for economic recovery and reflation. From my time in the White House and U.S. Treasury (1969-1984), I had a first-hand view of the negative impact of Vietnam War deficit spending during a gold-standard, fixed exchange-rate regime. Inflation was already at 6% and the fed funds rate at 9% in 1969.
Failing to garner international support for its dollar-adjustment needs under fixed exchange rates, President Nixon in 1971 suspended U.S. dollar/gold convertibility, imposed a 10% import surcharge and a 90-day freeze on wages and prices. In March 1973, the U.S. dollar fixed exchange rate system ended and so exchange rate adjustments were no longer a tool of monetary policy.
Later, in October 1973, OPEC proclaimed an oil embargo against the U.S. and other countries perceived as supporting Israel during the Yom Kippur War. It lasted until March 1974 during which the price of oil tripled, pushing inflation to 12.3% in 1974. Monetary policy left businesses confused and kept prices high with rising unemployment. The Iranian revolution triggered the second oil shock in 1979, raising oil prices and pushing inflation back up to 13%.
The Federal Reserve raised the fed funds rate to 18% in 1980 and wrung out inflation, which fell back to 3.8% in 1982, and it has remained at or below 4.4% except for a few brief periods. The Fed has been vigilant in balancing its price stability and full employment goals. It was observed in 2019 that full employment becomes broadly dispersed among all labor market segments, including minority and disadvantaged labor groups, only later in the economic growth cycle when headline unemployment is below 4%.
With annual inflation rates below its 2% target for the last 12 years, the Fed last year adopted an “average inflation rate” of 2% metric to help advance its goal of extending employment opportunities more broadly. There has been ongoing discussing of what this means, and, in particular, how it applies today as the Fed has continued its low interest rate, quantitative easing policies well into the economic recovery with its own projection of PCE inflation being 3.4% for 2021 (June 2021 FOMC).
Recent testimony by Fed Chair Jerome Powell, and comments by Fed bank presidents, confirms that the FOMC is comfortable with the current inflation trajectory and its carefully thought belief that current inflation spikes are transitory and not fundamental changes. Its continuing discussion of bond-buying tapering further reflects its confidence in markets having sufficient liquidity and lower Treasury net new issue requirements.
All of this suggests that higher rates of inflation are a reality, in the short-term at least. At present they don’t seem to be a risk for U.S. bond (or equity) markets, as global deflationary pressures are a counterweight at least through 2022. The FOMC meets next on July 27-28 and then again at its Jackson Hole retreat on Aug. 26-28, to “talk” about its next steps with respect to tapering and the course of the economy, inflation and interest rates.
Inflation will continue to be a topic throughout our industry in the coming months. Keel Point will host a webinar —
