Life – often there is little change to our daily comings and goings. Sometimes that change can be measured in inches or incrementally and once in a while life changes in an instant and forever alters our existence. Many would agree that the health, financial, political, social and societal repercussions stemming from the pandemic would at least fall into one of the latter two. It is the intent of this column to focus on the financial changes, specifically as it concerns inflation along with the duties of the Federal Reserve as it pertains to the Consumer Price Index (CPI), a measure of inflation at the retail level.
In 1977, Congress passed the Federal Reserve Act and in so doing directed the Open Market Committee of the Federal Reserve to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
Up until 2020, the charges outlined above underwent little change. However, in response to continuously low inflation, on August 27 of that year the mandate was amended to the following. “Employment, inflation, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Monetary policy plays an important role in stabilizing the economy in response to these disturbances. The Committee’s primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate. The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. Owing in part to the proximity of interest rates to the effect lower bound, the Committee judges that downward risks to employment and inflation have increased.”
To paraphrase, the economy can operate closer to full employment than was originally thought without causing a spike in inflation. This conclusion that the Fed drew was a result of a near decade long rate of inflation that was well below the Fed’s 2% annual target. Evidence of this is the fact that, for the decade ending December 31, 2020 inflation as measured by the CPI rose by an average of 1.75% per year, the smallest rate of annual increases since the 1930s when prices fell by an average of 1.30% per year. This, despite the fact that the yield on the ten-year U.S. Treasury Notes rarely rose above 3.00% over that timeframe.
Then, in March 2020 the pandemic hit and prices fell sharply. During April 2020, the Consumer Price Index (CPI) fell 0.4%, its largest monthly decline in more than sixty years (1957). Commencing at approximately the same time and continuing to this day, the Federal Reserve through the U.S. Treasury and authorized by Congress, this Presidential Administration and the previous one have embarked on a massive stimulus package, totaling trillions of dollars and consisting of monetary stimulus, a low interest rate environment, the purchase of U.S. Treasuries, mortgage-backed securities and loan forbearance programs. Couple this with pent-up demand, early retirements, the health or family related resignations and you have a recipe for inflation.
The question is whether or not this inflation will be short-lived (transitory) or longer-term in nature (secular) where it gets embedded into the economy and expectations for higher prices in the future rise. We believe there are components of both – ergo “SECULATORY.”
We draw this conclusion by examining the three basic components to production manufacturing, logistics (shipping) and labor. As of now and assuming current social issues do not become widespread (see the blockade of the Ambassador Bridge in Ontario), it is our belief that inflation within the first two components of production will abate. However, fortunately individual labor costs will continue to rise which should, in turn add to economic growth as most of these gains will be used to purchase goods and services. We write individual because, in the aggregate we believe that the increase in labor costs will ultimately be muted as the disinflationary impact of technology that caused the low rate of inflation during the 2010s will begin to reassert itself. Nonetheless, we do expect an inflationary environment in the 2.50% to 3.50% range, similar to the first decade of this century and not like the 1970s, a period of runaway inflation.
Given the rise in the two-year U.S. Treasury note to around 1.50%, the bond market is already pricing in six 0.25% hikes in the Federal Funds rate, the rate at which banks borrow excess reserves held at the Federal Reserve. Given our belief that rampant inflation is not presently a concern, we believe the Fed should take a measured approach. One that is deemed too aggressive may very well bring about a recession. The potential for this is already evidenced in the flattening of the yield curve.
The bottom line, during the second half of 2022, along with a partial rectifying of the manufacturing and logistics component to production, the disinflationary impact of technology along with the Quantitative Tightening (QT) process beginning next month, the Federal Reserve should be able to at least begin to substantially curb the recent rise in prices.
For equity investors we recommend utilizing a barbell approach. On one side investments that pay dividends and perform well in an interest rate environment as described above along with secular growers on the other. Regarding fixed income, at least for the next quarter or two expect a continuation of the pressure on prices as short-term yields trend higher. We would also use market weakness rather than strength to deploy additional capital as we expect continued volatility.
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, Please call 518-279-1044.
